Outline for Econ 130
Fall 2020
Pre-class survey
Before class, everyone should have completed a pre-class survey, in order to set-up and familiarize
themselves with Mob Lab.
Collects information on students motivation, interest in the course, expectations and major
Email to students before class
Hello Econ 130 students,
I hope you all have a restful and rejuvenating Thanksgiving. I know am looking forward to the upcoming quarter. While the
format will be unusual, I am confident you will learn a lot, and we can have interesting discussions using our new collective
knowledge.
You can now check out the Katie page for this course. I have posted the syllabus, all the handouts I will be using during lecture,
and all warm up activities. If you would like to print these out before the break, you can do so now. These handouts will
reduce the note-taking burden. I recommend you plan to print them out at home, over break, or before leaving campus. All
assignments will be electronic, with the option to print them out and submit pictures or scanned answers.
Course Expectations:
This semester, I have been working to restructure my course to be more engaging and interactive. I am planning for us to meet
in person for the full 3 hours each Tuesday and Thursday (typically, but sometimes classes will be shortened), and you should
plan to have 1-2 assignments between each class.
Course Policies and expectations are further outlined in the syllabus on Katie.
Course Materials:
The textbook (The Economy) for this course is open source. This means you can find it online for free (https://www.coreecon.org/the-economy/). Alternatively, you can purchase a hard copy.
This semester, you will additionally need to purchase a subscription to MobLab. You will need to purchase an access code
(through the bookstore or through the online website). Once you have an access code, you can link up to the class page with
the course code. During class, and for assignments, we will use the Moblab to play games and do surveys. You can access the
app through a laptop, tablet, or smartphone. If you think you will have trouble using this service, please let me know as soon as
possible.
You can purchase a registration code through Luther’s bookstore. Alternatively, you can register directly with the company
online (go to https://moblab.com/, click to “Sign Up”, and follow steps). The class code for Econ 130B is “z7rz7raw3”. Additional
information about how to sign up is provided on the Katie page.
Your First Homework Assignment
Two days before class begins, I will send a moblab registration reminder and post your first homework assignment (which must
be completed through MobLab). This assignment is due Tuesday, December 1st at 8 am.
I have been assured by MobLab, students who drop the course are able to get refunds for the subscription. Please do not delay
in registering for MobLab.
Let me know if you have any questions or concerns.
I look forward to seeing you soon!
Best,
1
Introduction

Welcome class

Warm-Up activity – What is economics?
Mob Lab survey(Handout1_WhatIsEconomics)
If students still are having trouble using it, now is the time to address the issue
If a student protests to using the app, you can use a paper copy of the activity
Give students 5 minutes to complete the two-question survey
Take 5 minutes to look at their answers, and refine
What is economics?
(My definition) Economics is the study of how people interact with each other and their
environment, in order to support livelihoods. Economics helps us understand how and why people
produce, trade, or purchase goods and services. Economics helps us understand how people,
businesses, and governments will respond to changes in markets, nature, or policy.
Literally: the science of household management (Greek origins of the word)
Historically, households were the dominant economic agent (the thing responsible for creation of
goods and services). As society developed, businesses grew and markets become more complex
What do economists do?

Analyze – use theory & data to examine success/failure of decisions & policies

Forecast – use theory & data to predict the future (markets, growth, welfare)

Design – use theory & data to make recommendations regarding personal, business, and
government activities
Economists can take different approaches to evaluating economic activities:
1) You can evaluate individuals features or linkages within an economy
i.e. a specific market, a specific industry, a specific actor (household, state, etc.)
This is what many micro economists do
2) You can evaluate the economy as a whole (big picture)
i.e. how is everyone in an economy affected by a policy
This is what many macro economists do
2

Go over syllabus: class policies & expectations
Point out: Office hours, course material, study tips, final exam, grading policy
Chapter 1 – The capitalist revolution

Vocabulary - Throughout this course, we will develop a common vocabulary that will help us learn
and apply economic theory. I will regularly update the class website with lists of terms and concepts
you should know – the list is not exhaustive, but should help you study for exams
o
Economic system institutions that organize the production and distribution of goods and
services
o
Institution the laws and social customs governing the way people interact in a society
o
Capitalism a particular economic system in which private property, markets, and firms play an
important role. In capitalist systems individuals or firms own inputs and outputs, and use
markets to exchange outputs to other individuals or firms
o
Private Property goods or resources owned by individuals or firms
Alternatively, governments could own good or resources, and the government could decide how
production should occur, and how goods should be distributed to people (as in a centrally
planned economic system observed in communist economies)
o
Capital Goods equipment, buildings, raw materials, inputs for production
Capital goods are typically privately owned in capitalist countries
o
Markets a place (which may or not be physical) where people or firms mutually benefit from the
exchange of goods and services

Transfer must be reciprocated (you can’t get something for nothing)

Transfer is voluntary (no one is coerced)

Both parties are better off after the transfer (or no worse off)
3

Gains from Trade – Learn by Competing (handout 2)
Explain game instructions & run game
Lead discussion questions

Refine student answers to discussion questions, making sure to note (or review after discussion)
Specialization is efficient (most output is created from given amount of inputs, or least amount
of inputs used to create output), or more productive, because
1) we learn as we do; our skills improve the more we do something,
2) we have differences in our abilities; we each have our own comparative advantage,
3) economies of scale – producing a large number can be efficient (per unit cost goes down)
That is, we benefit from allowing people to exploit their comparative advantage.

Absolute advantage: A person or country has an absolute advantage in the production of a
good if the inputs it uses to produce this good if the inputs it uses to produce this good are
less than in some other person or country

Comparative advantage: A person or country has a comparative advantage in the
production of a particular good if the cost of producing an additional unit of that good
relative to the cost of producing another good is lower than another person or country’s
cost to produce the same two goods
In a way, each group agreed upon some sort of price (who does what in exchange for what) for
the trade of goods (answers to questions)
Price – How much of one good is exchanged for another
Typically, we think of price in dollars, but this is only because we use currency to
simplify transactions (we will discuss this in detail later on)

Gains from Trade – a numerical example (similar to Chap 1.8 in Core)
Handout 3 – a numerical example of gains from trade
Make sure to define/clarify
Production = (amt of input) x (output/unit of input)
Opportunity Cost – the cost of doing one thing instead of the next best alternative
If you do one less of X, how much of Y do you give up?
How to decide who does what? (connect comparative advantage and opportunity cost)
4
Thinking Like an Economist
 How do we decide what to do?
Your friend wants to go see movie _________________ at the Viking 3
The movie seemed somewhat interesting to you, but it received lukewarm reviews. You are trying to
decide whether or not to go.
What factors should you consider? (poll the class)
An economist would make their decision by creating a model –
1) organize relevant facts, 2) think about your objective/preferences, and 3) achieve your objective
Relevant facts:
You could go to the movie (option 1) the ticket costs $8.00
Once you account for travel time, and previews, you think going to the movie will take 2.5 hrs
If you did not go to the movie, what would you do? (what are your alternatives?)
(option 2) Hang out with a group of your friends for 2.5 hours
(option 3) Study economics for 2.5 hours
Think about your preferences or tastes.
You consider the reviews of the movie, and the excitement of going off campus, and decide that
seeing the movie in theaters is worth $14
Hanging out with a group of your friends for 2.5 hours, which is worth $7
Study economics for 2.5 hours, which is worth $5
5
Opportunity cost: the cost of doing one thing, instead of the next best alternative.
 If you don’t go to the movie, next best option is hanging out with friends
 OC of going to the movies is $7, hanging out with your friends
Total economic cost = accounting cost + opportunity cost
Accounting cost – out of pocket = $8
Opportunity cost = $7
 Total economic cost = $15
To answer the question: should I go to the movies? We need to see if going to the movie maximizes our
happiness in terms of $
That is…will we have positive economic rent?
Economic Rent = Total Benefit – Total Economic Cost
= $14 - $15 = $-1
Make a decision to maximize your happiness
If economic rent <0, don’t do it! Costs outweigh benefits
If economic rent = 0, you are indifferent
If economic rent is >0, do it!
If there are multiple possible actions, do the activity that gives you the highest rent
6

(If time allows) Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations 1776
Invisible Hand: What we observed (markets, prices, production, innovation) was the result of
individuals acting in their own interest (and responding to features of markets)
o It appears as if millions of independent economic actors (producers, consumers,
transporters, sellers), who do not necessary know one another, organize themselves (in
markets, supply chains, activities) without instruction of a master planner.
Who here buys their textbooks on amazon? Why do you do that?
Who here buys their textbooks on campus? Why do you do that?
This is the invisible hand at work. In both cases, no one forces you to buy your text books from one place
or the other.
An economist would say your preferences, understanding your alternatives, guides you to the
decision that is right for you!
Review the different models we have used to understand gains from trade and how to make a decision…
Stress that these are models – or abstract representations – of a problem. We do not think people
literally make mathematical calculations before reaching a decisions….but they approximate our
decision making process.
7

Chapter 3: Scarcity Work and Choice
Decision-making under scarcity
o
How do people decide how much of something to buy? How much of something to do? How
much of something to make?
Constrained optimization
o
If we could, we would buy, do, or make a large amount of all things ‘good’
(our objective is to maximize a good thing or minimize a bad thing)
o
But we are often limited by how much money we have saved or make, how much time we
have, or other resources needed as inputs.
o
Constraints are limited resources that are needed to obtain the things we want
When economists talk about constrained optimization, they are referring to a decision-making
process to achieve the best outcome (achieving the most happiness, largest profit, smallest cost)
while accounting for limited resources.
The goal of the next two lectures is to learn how to use economic models to carry out constrained
optimization problems. We will discuss it using three examples:
1. How much time should a fisherman spend fishing?
2. How much pizza and beer should a student buy?
3. How much sushi and nigiri should a sushi eating panda eat?
To answer all these questions, we need to:
organize relevant facts (define goods, constraints, production and prices),
think about your preferences and objectives
and make your decision (achieve your objective)
8
Example 1: How much time should a fisherman spend fishing? (Pass out Handout 4)
Step 1: Organize relevant facts
Define… relevant goods, constraints, and potentially production processes, and maybe prices
In this simple model of the fisherman’s decision:
Goods:
Fish is a good – its something desirable that is made by the fisherman (for consumption)
His time is a good – your time is a desirable thing that can bring you enjoyment
Here, we will refer to his free time (not fishing) as leisure
Inputs:
His time is also an input – he can use his time to harvest fish from the ocean
Here, we will refer to his time spent fishing as labor
(Traditionally, economists think of labor as a bad (its not fun to work!))
Constraints:
The fishermen does not have infinity time, there are only 24 hours in a day….
He has a time constraint (Leisure + Labor = 24)
Notice: Leisure and labor are opposites
Production processes: how are inputs turned into outputs (goods)
Economists observe data of inputs and outputs, and come up with a mathematical model to
describe the relationship they observe
Draw the graph and label axes and curve (Make sure: Fish is on Y axis, Leisure is on X axis)
Talk about properties of this production function

output increases with input

curved production function…what does it tell us?
Derive and discuss the interpretation of MRT with two examples (low input…and high input)
Define and discuss:
Feasible set
Feasible Frontier (aka production possibility frontier)
Marginal Rate of Transformation (change in Y/change in X)
this refers to the tradeoff required of one good in the creation of another good.
9
Step 2 - think about preferences and objectives:
Objective: What is the fisherman’s objective? What is he trying to achieve?
Do you think his objective to maximize his own happiness or the happiness of his family?
How might that affect what he decides to do?
Note other type of objectives:
Maximize profit
Minimize Cost
Maximize production
Minimize unhappiness
Maximize votes
Minimize unemployment
Preferences: How do we value or weight the goods and options available to us?
Generally, we like to have more of good things, and less of bad things
But our preferences are unique, so they may be different than another person.
Think about this: You are considering two jobs after college…
Job 1: Salary = $75,000 a year, expected to work 80 hours/wk, and you get 4 weeks vacation.
Job 2: Salary = $45,000 a year, expected to work 60 hours/wk and you get 6 weeks vacation
Raise your hand if you prefere job 1….job2….
Economists use surveys or observational data to understand people’s preferences.
For example, we could ask a fisherman, how many fish would you give up in order to have two
more hour of free time (and maintain your currently level of happiness)…show on the IC graph
Or we could ask, how many hours of free time would you give up in order to have 20 more fish
(and maintain your currently level of happiness)…show on the IC graph
This is an indifference curve
It tells us which combinations of goods achieve the same level of happiness
Along this line fisher is indifferent between all options (no preference for any particular combo)
10
Properties of indifference curves: (go over rule, and intuition behind it)

Indifference curves slope downward – when you give up one thing, you expect more of another

Higher indifference curves correspond to higher utility – moving away from the origin means the
individual is achieving a greater degree of utility (or happiness)

Indifferences are usually smooth (don’t go over in detail)

Indifference curves do not cross (don’t go over in detail)

Indifference curves get flatter on the ends
Why do indifference curves get flatter on the end? (Hint too much of a good thing)
If you have a lot of free time…getting an extra hour of free time is not very valuable…
Moving from 23-24 leisure hours….fishermen is not willing to give up much fish
Define the marginal rate of substitution
this refers to the willingness to tradeoff of one good for acquisition of another good
Discuss IC graph 2 and 3
Point out higher IC / lower IC
Which IC represents a person who places a higher value on their free time?
(answer… gray IC…is willing to give up more fish for additional leisure time)
11
Step 3 – Make your decision:
to predict how much time the fishermen will fish, we need:
1) indifference curves (explains the fisher’s preferences for fish and free time)
2) feasible frontier (explains the most efficient way to turn input (time) into fish (output))
From these two things, we have
1) marginal rate of substitution, and
2) marginal rate of transformation
Have them try to work on the problem (what is the optimal decision),
Then come back together as a group and discuss
Note: The optimal combination of free time and fish is the point that has only one point of intersection
with an indifference curve. (Indifference is tangent to the frontier).
Also Note: this was where MRS = MRT
Go to the last page in hand out 4
Look at point with fish = 140, leisure = 2
Here MRS>MRT… not optimal: your preferences say you have a strong desire to give up
fish to get more free time…and guess what? You don’t have to give up much fish if you
give up some of your time! (That is, you can easily turn time into fish!)
Look at point with fish = 50, leisure = 19
Here MRS<MRT… not optimal: your preferences say you have a strong desire to give up
time to get more fish…and guess what? You will get a lot more fish if you give up just a
little bit of time!
12
Example #2: How much pizza and beer should a student buy? (handout 5)
If running behind…encourage students to complete HO before next class (then use as warmup)
Step 1: Organize relevant facts
Goods:
Pizza and beer (why is time (labor or leisure) not a good in this problem?...because its just a
model focusing on these two goods!)
Inputs:
Use money to purchase both goods
Constraints:
The student has a fixed amount of money ($40) to spend in a week.
This is a budget constraint ($ spent on beer + $ spent on pizza <=$40)
Because this is a simple model, we will assume there is nothing else to spend the money on, and
no incentive to save (unrealistic, but it’s a model…we can make simplifications!)
Production processes: we buy pizza and beer at set prices
Talk about properties of this feasible frontier

if you buy more pizza, you have to buy less beer (constrained by budget)

because prices are fixed, it’s a straight line, with slope = price pizza/ price beer
(beer is $4 and pizza is $2, so the slope = ½)
MRT = how much beer do you have to give up to get one more slice of pizza?
MRT is an expression of opportunity cost (in terms of beer/pizza)
But because we buy these from the market, the exchange is determined by prices
Step 2 - think about preferences and objectives:
Student wants to buy pizza and beer in order to maximize their happiness or utility
(What does this IC tell us? How do you know?)
Step 3 – Make your decision:
Ask students to identify optimal allocation of beer and pizza (5 cans of beer and 10 slices of pizza), and
how much money is left over ($0)
13
Price Change:
Have students take time to work on the answers to this new problem (price of beer dropped)
Look to key for answers.
Extra observations (make the connection between MRS and MRT one more time).
Note:
MRT = price of pizza / price of beer
MRS = mu pizza / mu beer
Optimal if….
𝑃𝑟𝑖𝑐𝑒
𝑀𝑈
MRT = MRS or 𝑃𝑟𝑖𝑐𝑒𝑝𝑖𝑧𝑧𝑎 = 𝑀𝑈𝑝𝑖𝑧𝑧𝑎
𝑏𝑒𝑒𝑟
𝑏𝑒𝑒𝑟
Here, optimal is when pizza = 10 and beer =10
Price of beer = 2 price of pizza = 2
𝑃𝑟𝑖𝑐𝑒𝑝𝑖𝑧𝑧𝑎
So…
𝑃𝑟𝑖𝑐𝑒𝑏𝑒𝑒𝑟
=
𝑀𝑈𝑝𝑖𝑧𝑧𝑎
𝑀𝑈𝑏𝑒𝑒𝑟
2
2
… =
𝑀𝑈𝑝𝑖𝑧𝑧𝑎
𝑀𝑈𝑏𝑒𝑒𝑟
14
Example #3: How much sushi and nigiri should a sushi eating panda eat?
Introduce the game: (also found in the open session survey in Moblab
In each period of this decision process, a panda must allocate a sum of money between
two types of sushi. Prices are given, as are the marginal utility to be gained from
consumption of an additional piece of sushi. One piece at a time, the student chooses
from the two types of sushi and continues doing so until the budget is depleted.
You will play X rounds.
In round 1-2, the prices of sushi are equal, and the panda prefers them equally
In round 3, preferences stay the same, but prices change
In round 4, preferences stay the same, but prices and incomes change
In round 5, preferences change, but prices and income return to original levels
In round 6, preferences and prices change.
Remember….when making an optimal decision, you should consider preferenc es
(marginal utility), prices (which determine marginal rate of transformation), and income
(constraint)

Flip through the instruction power point

Run through surveys and games

Go over results
o
Ask people about their strategies (in between rounds)
o
Ask if they found any rounds hard to complete? Ask other people their
strategies for completing the round.
Introduce HW 3 – and show people the schedule
Give an example!
15
Unit 4: Social Interactions
Game theory –
Used to understand strategic interaction between people, firms, and governments.
We need some new vocabulary:
Social and strategic interactions
o Social interaction: A situation in which there are two or more people, and the actions taken
by each person affects both their own outcome and other people’s outcomes
o
Strategic interaction: A social interaction in which the participants are aware of the ways
that their actions affect others (and the ways that the actions of others affect them)
o
Strategy: An action (or course of action) that a person may take when that person is aware
of the mutual dependence of the results for herself and for others. The outcomes depend
not only on that person’s actions, but also on the actions of others.
Redefine the steps solve a problem when using a game – A model of strategic interaction that describes
1) Gather relevant information
 Players who is making decisions (who is interacting with whom)
 Feasible strategies which actions are available to each person
 Information each player knows when they make a decision
2) Determine game play (timing) and payoffs
 Payoffs describe the outcomes (value of all possible outcomes)
3) Solve the game (Identify equilibrium)
Pass out Handout 6 – Moving Day Game
In our example of trade (gains from specialization) Richarda bossed David around…but in the Food Truck
game, no one dictated what we should do. Generally speaking, economic theory tells us you don’t NEED
to have coordination or someone dictating who should do what…if markets are functioning, people can
figure it out by doing what is in their best interest. We can use game theory to illustrate how Richarda
and David could figure out the best way to specialize, even if Ricarda did not dictate:
If there is a market, then people should eventually figure out that there are gains from specializing. They
do not need to interact with each other, they just need to participate in markets
16
Complete the worksheet, and suggest annotations to the tables (for notes)
* players (David and Ricarda)
* Feasible strategies (unpack or move…no splitting of time for simplicity)
* Information: Players know…
* other player and their feasible strategies
* possible outcomes
* payoffs (theirs and the other players)
* game is one-shot (one-time decision, no repeats)
* players decide simultaneously (at the same time)
* Payoffs – go over how to read the table (what payoff goes where)
Also, discuss the interpretation of payoffs (may come from preferences, and so, unique)
* Solve the matrix to find the equilibrium (Go through the process)
4.2 Go over some key terms – make sure you make these explicit:

When predicting the outcome of a game, we need to understand the best response of each of
the players. That is, the strategy that gives each player the highest payoff given the action of the
other player
o Even when the game is simultaneous, we still thing of the best response function

Payoff matrix:
o Always read description carefully, to know which payoffs correspond to which players.
If it is not obvious…ask!

Steps to find best responses (figure 4.2b)
1. Being with the row player and ask: “What would be his best response to the column
player’s decision to one of their strategies?”
2. Place a dot in the cell representing the row player’s best response
3. Repeat 1 and 2 for the case where the column player plays his other strategy
4. Check to see if the row player has a dominant strategy
5. Repeat 1-3 for the column player
6. Check to see if the column player has a dominant strategy
7. Determine the equilibrium

Dominant strategy: Action that yields the highest payoff for a player, no matter what the other
players do

Dominant strategy equilibrium: An outcome of a game in which every player plays his or her
dominant strategy – neither of the players want to change their decision given the response of
the other player
17
Play prisoners Dilemma game on Moblab
Review: If we thought of this as a one shot game….what equilibrium would we expect?
Player
1
C
D
Player 2
C
D
10 \ 10 2 \ 14
14 \ 2
6\6
Is this what happened when we played? (Look at results)
Would anyone who did not choose D as their strategy like to explain their motivation?
When we play repeated games, things are more complex…outside the scope of this class.
Formally explain what prisoner’s dilemma is: (4.3 The Prisoners’ Dilemma (141-144))

Prisoners’ dilemma: A game in which the payoffs in the dominant strategy equilibrium are lower
for each player, and also lower in total, than if neither player played the dominant strategy
The example in the book also has an environmental application. In class, I am going to present this in a
more classical way (with prisoners)

Players: 2 accomplices of a crime (or maybe two innocent people who are suspected of a crime!)

feasible strategies, which actions are open to the players; Confess or not confess to the crime

information, what each player knows when making their decision; The detective told them they
would get a deal if they confess and act as a witness when they try the other suspect. But that
deal will only hold if they confess right now.

payoffs, what the outcomes will be for each possible combinations of actions; years in prison
Outcomes:
Prisoner 1
Confess
Prisoner 2
Confess
10 yrs \ 10 yrs
Don’t Confess
2 yrs \ 20 yrs
Don’t confess
20 yrs \ 2 yrs
5 yrs \ 5 yrs
Prisoner 2
Confess
Don’t Confess
Confess
100 \ 100
200 \ 50
Don’t confess
50 \ 200
150 \ 150
Payoffs:
Prisoner 1
*Go over how to solve the game (slowly and carefully)
18
Point out 3 conditions for a prisoner’s dilemma game are met:
1. Both players have a dominant strategy
2. There is a dominant strategy equilibrium
3. The equilibrium is not the outcome that would maximize total welfare
Review game theory
Play 3 rounds of games and corresponding surveys (this will serve as a good review)
Anthony Davis
Coke and Pepsi
Dinner Date
Review key terms:
Best response function – plan of which strategies to play when
Dominant Strategy – a special case, which player should always play a single strategy
Equilibrium – the outcome at the intersection of best response functions…that is, no one would change
their strategy, given the strategy played by the other players.
Dominant Strategy Equilibrium – a special case of equilibrium - all players have a dominant strategy
Prisoners Dilemma – a special case of DST, when a sub-optimal outcome occurs
19
4.8 Behavioral experiments in the lab and in the field (155-159)

To study preferences, economists traditionally have used the following sources of data
o
Self-reported responses to survey questions or experiements

o
Problem is they are not incentive-compatible
Statistical studies of revealed preference in economic behavior

Revealed preference: A way of studying preferences by reverse engineering the
motives of an individual (determined from observations of actual actions)


Challenge is that behavior may be driven by some other omitted variable
Social preferences: Preferences that place a value on what happens to other people, and on
acting morally, even if it results in lower payoffs than purely self-interested sense

Social preferences include:
o
Altruism: The willingness to bear a cost in order to benefit somebody else
o
Fairness (inequality aversion): A way to evaluate an allocation based on one’s
conception of justice
o
Reciprocity: A preference to be kind or to help others who are kind and helpful, and to
withhold help and kindness from people who are not helpful or kind
BUT REMEMBER, these alternative motivators are baked into the payoff numbers…so if a person values
equity, the payoff in the matrix accounts for this preference!!!
Illustrate this with two different payoff matrices that tell different stories

Have two people choose between steal/share
o
In one scenario, both people are selfish
o
In another, one is selfish and one person gets warm glow from sharing, so boosts payoff
20
4.11 Fair farmers, self-interested students? (164-169)
*MobLab > Ultimatum game (explain how it works)
Play three rounds of the ultimatum game
Survey
Ultimatum game 2 (ppl compare their willingness to accept/and offers
Lead discussion about why people played the way they did
What would you do if there was a Two respondent ultimatum game
Set up new rules….write it out for clarity:
Proposer makes an offer to two people
Both respondents accept or reject
If one accepts, the other rejects, accepter gets it
If both accept, 50% it will go to one in particular
How might this change what you are willing to accept?
How might this change what you are willing to offer?
Reduces “punishment” for an unfair spilt
If you thought things should be 50-50, but the other respondent just wanted some money,
and would be fine with 70-30, then they will agree to offers you would not agree to.
In the real world…this is like low wage jobs, or poor working environments.
Even if you think its unfair, you may accept a low-paying job, or endure conditions you don’t like because
you know that there are many other people who are content or willing to accept these same conditions.
Handout 7: Sequential Games
Explain the general structure of a game tree, and do at least the first example
21
Unit 6: The Firm: Owners, Managers and Employees
Establish some new terms/concepts

Division of Labor: gains from specialization in the allocation of labor

Markets allow people to produce/purchase different things

o
Example: Some people teach, farm, make beer
o
Markets represent decentralization of economic power
The coordination of work (What is a firm?): Within the same firm, people have different
responsibilities or jobs
o
A firm represents concentration of economic power, placed in the hands of the owners and
managers. Instead of lots of individuals making their own decisions…someone is directing
actions of all the employees

Asymmetric information – information that is relevant to the participants in an economic
interaction, but it is only known to some of the participants.
Asymmetric information + Separation of ownership and control principal-agent problem

Owner is the principal and the Manager/employee is the agent
Problem of monitoring: ask students for ideas about how to monitor effort and point out limitations.

A firm cannot write an enforceable employment contract that specifies the exact tasks
employees have to perform in order to get paid, for several reasons:
o
1. It cannot know exactly what it will need the employee to do, because this will be
determined by unforeseen future events
o
2. It would be impractical or too costly for the firm to observe exactly how much effort
each employee makes in doing the job

Contracts may help reduce problems related to asymmetric information (but not eliminate!)
o
Contract: A legal document or understanding that specifies a set of actions that parties
to the contract must undertake
22

Firm’s profits depend on the following
o
o
Costs of acquiring the inputs necessary for the production process, including:

Hours per person

Wages

Number of employees

Employee Effort
Output (how much these inputs produce) and price (of sold output)


Sales revenues received from selling goods or services
Wage labor: A system in which producers are paid for the time they work for their employers
Firms want to maximize their profit:
Firm Profit = Revenue – Costs of Production
In a simple model, labor will be the only cost, and effort of that labor impacts the revenue
Employees want to maximize employment rents (profit/net benefit of being employed)
We often use the concept of employment rent to explain when and why individuals choose to work,
quite their jobs, or exit the labor market completely.

What motivates people to do good work?
o

What is the rent = benefit – economic cost of working?

Ask: students to come up with benefits and costs of working

Also: Make sure to avoid being fired (which is part of a more complex model)
Do workers care whether they lose their job?
o
Simple answer: if firms paid lowest possible wage, then no (indifferent)
o
But: wage + benefits are valued more than the extra hour of free time (benefits
outweigh costs) so its preferred to keep your job…

This means, if you think it is more valuable to work at current payment than it is
to be unemployed, this means employment rent > 0
23
Determinants of the employment rent (The detail)
Employment Rent = Total Benefits – Total Costs
o
o
Costs of working
 Disutility of work
 Psychological costs
 Cost of traveling to work every day
Benefits of working
 Wage income
 Firm-specific assets
 Medical insurance
 Social status
Employment Rent per hour = wage (benefits per hour) – disutility of effort (costs per hour)
> How hard should I work?
Handout 8: Labor Market
Fill out the first page
Total employment rent = Employment rent per hour x expected lost hours of work
Expected lost hours of work = the number of hours of work lost if the job is terminated
> Should I keep my job or quit?
Suppose if the employee lost their job (or quit), and they would work 40 hours per week, and they think
it would take 2 weeks to find a new one….
Draw this problem as a timeline/diagram
With wage only: Total employment rent = 18*40*2 = 1440
With wage and profit share: Total employment rent = 80*40*2 = 6,400
Discuss: When would an employee quit their job?
Have we uncovered any economic insights?
24
What happens when we include unemployment benefits?


Unemployment benefits
o
When government provides support for unemployed people
o
Reservation wage is the hourly equivalent of unemployment benefits
Involuntary Unemployment: being out of work, but you would prefer to have work at the current
wages and benefits of job that could be possible.
o Explain intuition
Employment rent per hour = wage – reservation wage - disutility of effort per hour
(Continue with example) Suppose if the employee lost their job (or quit), and they would work 40 hours
per week, and they think it would take 2 weeks to find a new one….AND for 1 week they could get $200
of unemployment benefits ($5 per hour)
Draw Diagram/Timeline
With wage only: employment rent per hour = 20 – 5 – 2 = 13
employment rent per hour = 20 – 2 = 18
for the first week
for the second week
Total employment rent = 13*40 + 18 *40 = 1240
Discus: When would an employee quit their job?
Have we uncovered any economic insights?
25
6.6 Work and Wages: The Labor Discipline Model (page 2 and 3 in HO8)

The game between firms and employees - explain
o Players
o Strategies
o Rules
 Order in which they choose their actions
 Information when they choose their action
 Payoffs
 Firm enjoys revenues less the cost of employee labor
 Employee enjoys value of her wage earnings
o Not just wage
o Value of her money she earns less the disutility of effort
But in this model, we have a more complicated representation of payoffs…
Look to see what it includes……
Why do you think we need this more complicated model? What do we gain from it
being more complicated?
Work through the problems
Discuss the economic insights – complications to the model (making it more realistic) can lead us to
different results….
--- Cost of training new employees
--- Risk of firing
26
(A few remaining points and summary)
6.7 Wages, Effort, and Profits in the Labor Discipline Model
Suppose an employee could immediately find the same employment (that pays more than the
reservation wage)





What is their employment rent? (value of keeping job rather than losing it?)
o The employment rent would be zero
What does this mean?
o This means the employee would be indifferent between keeping the job and losing it
What would be the employee’s best response?
o The employee’s best response would be giving no effort
Could this be an equilibrium?
o This cannot be the equilibrium, because the employer would not pay more than the
reservation wage for someone who would give no effort
What does this mean?
o In equilibrium, both wages and involuntary unemployment have to be high enough to
ensure that there is enough employment rent for workers to put in effort
Efficiency wages


The payment an employer makes that is higher than an employee’s reservation wage, so as to
motivate the employee to provide more effort on the job than he or she would otherwise
choose to provide
Owner recognizes that what matters for profits is efforts over wages, not just wages
Recap - Review previous concepts that are important for this chapter

People have to make a tradeoff between free time and work (which supports livelihoods)

Production, and thus, wages and living standards grow as society develops new technologies.

Two economic agents must bargain with each other to divide up surplus (econ rents)

There are gains from specialization (division of labor) – this could be between people or within a
firm (organization)

Preferences of the individuals working together may alter the ability (or strategy taken) to
succeed
TELL STUDENTS TO REVIEW FOR TEST! OFFER Q&A opportunity
27
Unit 8: Supply and Demand
In the earlier chapters we have been developing models of individual decision making

How much time does a fishermen spend fishing?

How much beer and pizza does a student buy?

Should someone keep their job or quit their job?

Should the firm pay a wage or a wage + share?

Should employee work hard, or slack off?
It’s true we can imagine using these models, and making variations of these models, in thousands of
ways, to examine thousands of problems.
But sometimes we have bigger-picture questions.
How much fish will a community of fishermen catch in a day?
How many beers and pizzas will be consumed in a week in Decorah?
How many people will the whippy dip employ in a given week?
What is the wage rate in the United States?
How productive will a company be (how much will be produced in a day)?
These questions require us to find the solution to many individuals each making their own decision.
Unlike a strategic interaction, people are making decisions which impact the payoffs of other, but they
are not aware or considering the affect they have on others.
Let’s first explore your own intuition through a simulation in Moblab:
Our class is going to be turning the class into an Orange Market
Some of you will be buyers – and you will have to buy 3 oranges
Some of you will be sellers – and you will have to sell 3 oranges
Buyers have different preferences, each of you have different marginal value for that first orange
Sellers have different costs, each of you have different marginal cost for the first orange
In this game, you need to make bids/requests, or you can accept highest/lowest bid.
Everyone’s goal is to max their own profit. Top 5 students get 2 points bonus towards discussion grade
talk about results, people’s strategies, and how we can learn about the market
28
Make sure to point out:

Even though people have different values and costs, we sort of converged into a price
o
And some people made a lot of profit, and some people made a small amount
This allows us to observe an approximate market price and observe how many transactions
were made
Let’s formalize this a little bit more:
When people engage in a market transactions, they are each considering the following question:

Should I buy X at price $Y? if yes, then buy. If no, then no.

Should I sell X at price $Y? if yes, then sell. If no, then sell.
Economists model decisions on the margin – basically asking if we should have one more?
Go to moblab
Go through the PSL survey and talk about willingness to pay
Note: People have different preferences, some value that first latte a lot, some not as much
After you consume that first one, most people value you the second one a little less
Take the data and start coming up with a demand for the entire class.
When figuring how much of a good someone will consume or use or buy…
Economists evaluate the first decision (consume of the first good)
Is the good worth it? Should we consume that first unit?
If yes… do it, then ask yourself….is the next unit worth it?
If yes… do it, then ask yourself….is the next unit worth it?
And so on, until its no longer worth it. And then you stop
29
So how do people make this decision?
Economists model the decision as examining the economic rent or profit from consumption
Buyer rent/profit = marginal Willingness to Pay – Price
If buyer profit > 0  buy.
If buyer profit = 0  indifferent.
If buyer profit < 0  don’t buy.
Go back to the demand graph and talk about how to determine how many total lattes will be purchased
by the class at a certain price.
The seller has to ask a similar set of questions, but their questions are framed…
Should I produce and sell one more unit of the good?
Seller rent/profit = Price – marginal Willingness to Accept
If seller profit > 0  sell.
If seller profit = 0  indifferent.
If seller profit < 0  don’t sell.
We can summarize buyer profit or seller profit as surplus
This just refers to the benefit from a transaction.
Adding up the surplus from all buyer’s transactions  total buyer surplus
Adding up the surplus from all seller’s transactions  total seller surplus
Total Surplus  Total buyer surplus + Total seller surplus  represents society’s benefit from all
transactions in the market
30
Handout9: Free Market for Lattes
Work through individual purchasing decisions
If there were just three people in the market…how many lattes?
Work through individual selling decisions
If there were was just one supplier in the market…how many lattes?
Now carefully look at the Excel spreadsheet “MarketForPSL” posted on Katie
This spreadsheet shows a more complicated market:
14 Buyers – all will different preferences
3 Sellers – some high cost, some low cost
Talk about the supply and demand graph
Finally, listen to the first 7 ish minutes of undercover economist, and fillout the reflection
questions. Then discuss with the class.
Now lets formalize the theory of demand and supply and learn a few new vocabulary terms
(turn to hand written notes)
31
Shocks to supply and demand:
When we look at a supply and demand graph, we are looking at a snap shot of a market.
Things change, either from the supply or the demand perspective
Either way, there could be a change to the quantity or price in the market, impacting
buyers or sellers (could be good or bad).
A shock is something that happens and effects demand and or supply.
Lets work through the possible impacts with Handout 10
Wrap up the chapter with an overview/formal definition of a competitive market (hand written notes).
32
Unit 7
Measuring costs of the firm
Increasing Returns to Scale (less common)
Sometimes, the marginal costs decline when amt produced increases
Firms might get deals or discounts from suppliers, or technology can work more efficiently
Implies increasing marginal returns (production function)
Decreasing Returns to Scale (more common)
More often, the marginal costs increase when amt produced increases
Firms have a harder time finding inputs, inputs get tired or work less efficiently
Implies decreasing marginal returns (production function)
We can, and sometimes do, consider different ways to summarize costs of the firm
Illustrate (graphically) what they are and define each at some quantity Q

Total production cost

Average production cost

Marginal production cost
33
Firm’s marginal costs (MC) or supply: marginal cost of suppling goods to the market
Marginal costs capture the variable costs – The costs that increase with output
These are different than fixed costs – the costs that do not increase with output
Discuss examples of each
Illustrate with a graph of supply and discuss features
Fixed costs determine when/if a firm will “shut down”, but does not affect the marginal decisions

When dining rooms are forced to close, will a restaurant shut down or offer delivery/pickup?
o
Some will shut down - high fixed costs
o
Some will offer limited service (low Q) – low fixed costs, medium/high marginal costs
o
Some will offer a lot of service (high Q) – low fixed costs, low marginal costs
Example (Luna Valley Farm, High Wide and Handsome, Mabes)
Let’s carefully consider the problem of the firm in a competitive market:
34
Review perfect competition conditions
When a market is perfectly competitive, firms (and buyers) are “price takers”
Price takers  cannot directly affect or change the price
When a market is competitive, a firm can only decide if and how much to produce.
If the firm tries to set a higher pricecustomers would look for a better deal with another firm
If the firm sets a lower price  customers will come to them for a better deal
Firms will undercut each other until the price = MC
If the firm sets a price lower than MC  firms would be losing money
In a perfectly competitive world: firms choose Q s.t. MC = P
Why? We can illustrate it using the supply and demand facing the firm
Handout 11: Firm decision making
Set things up. Go over the market and the firm graphs
Firm’s Residual Demand (market demand facing the firm)
Review the price setting options of the firm…and explain why the residual demand curve is flat
Firms objective is to choose Q that maximizes profit
Profit = Total Revenue – Total Cost
 Find the Q s.t Marginal Revenue = Marginal Cost (from calculus)
This is the key rule. A firm will maximize profit by choosing Q s.t MR = MC
But the trick is, for a competitive market, the firm’s residual demand is flat
So the price is not a function of quantity selected by any one particular firm
This means that the marginal revenue is equal to the price
TR = P*Q

MR = dTR/dQ = P
35
From the firm’s perspective: the only viable price is the market price
Draw revenue
Cannot increase the revenue by changing the price, but can make additional units
If producing more Q increases Revenue and so, increases profits….
why wouldn’t the firm produce infinity Q?
(We have “many” buyers, so demand is not the problem)
We need to think about the marginal costs!
Total cost of production is the area under the supply/marginal cost curve
Illustrate cost at low level, medium level, and high (unprofitable level)
Recap with the profit maximizing Q of a competitive firm
Now, back to notes (we will return to the handout after we cover a few things)
What happens when there is only one firm in the market?
This is an extreme violation of the first condition of a competitive market (many sellers)
One firm in a market is a Monopoly
(a small number of firms = oligopoly, single buyer = monopsony, few buyer = oligopsony)
In this class, we will just look at a monopoly, but we consider these other market situations in
other economics classes. But we can still learn a lot, even with a simple model
A Monopoly has the power to set a price (it’s a price setter).
Why? Do over the intuition
36
When there is just one firm, the market demand = residual demand.
This means the price the monopoly chooses will directly effect the quantity purchased
The firm still wants to maximize profit, which means setting MR = MC
Now, we need to consider what the marginal revenue looks like (because it is not = to P)
Fortunately its not hard to figure out with our simple linear demand equations
TR = P(Q) * Q

MR = dTR/dQ = dP(Q)/dQ*Q + P(Q)
When P(Q) = b – m*Q
MR = -m*Q + b – m*Q
MR = b – 2*m*Q
That is, MR for a monopoly has the same y-intercept as the demand curve, and is twice as steep.
(You will never need to derive this equation in this class. You will need to recognize and understand the
graphical representation. I wanted to show you were this graph came from).
To find the optimal price and quantity set by the monopoly: (Show each step on its own graph)
1. Find the Q at which MR = MC
2. Find the max price the firm can set to achieve this level of Q
Show on a third graph, the total cost, total revenue and total profit of the monopoly
Show on a fourth graph the total profit of the monopoly if it had instead sold at the competitive market
price and quantity
Explain why/how you can see that this area (i.e. profit) is smaller than the monopoly price
This is still an equilibrium. Given the price, consumers can’t make themselves better off. And the
Monopoly can’t do anything else to increase its profit.
We have achieved the condition: Cannot make anyone else better off (the buyer)
without making someone (ie the firm) worse off
BUT this is not a perfectly competitive equilibrium
37
Why are monopolies “bad” for society
Its easy for policy makers to blame them for problems because their market power comes at a cost
borne by the consumers. That is, when there is a monopoly, lower Q is sold at a higher price P
Another way to say this, is the total surplus decreases. Particularly, the consumer surplus is lower in a
monopoly compared to a competitive market.
Carefully draw producer, consumer and total surplus for both a monopoly and a competitive market
So who wins and who loses when there is a monopoly?
Producers are better off (higher surplus)
Consumers are worse off (lower surplus)
Notice producers capture consumer surplus
Society as a whole is worse off
Define and illustrate deadweight loss.
We will use this same approach to evaluate other types of policies (and it’s a big part of 200-300 level
economics courses)
(7.7) Final thoughts
We can think of surplus (producer, consumer, and total surplus) as a representation of gains from trade
Discuss intuition briefly
A perfectly competitive market  maximizes efficiency = maximizes total surplus = maximize gains from
trade
38
Unit 9 – The Labor market, wages, profits and employment
Now we are going to focus on a particular market: the market for labor in an economy
To be clear, we are thinking about a community (could be a town, city, state, country, etc.)
Supply of labor = individuals who are willing to trade their time/work/effort for pay
Workers supply labor to the market
Demand of labor = firms who want to pay individuals for their time/work/effort
Firms demand labor from the market

We are talking about large numbers of individuals & firms (that is we are talking about many
sellers and buyers of labor…this is condition 1 of a perfectly competitive market)

We may not, however, have negligible transactions costs:
It takes workers time/money to find a new job if they quit their current job
It takes firms time/money to find a new employee

Additionally, we do not have perfect information: Firms cannot observe worker effort perfectly
So remember, we will characterize the labor market equilibrium price and quantity.
But it is not a perfectly competitive equilibrium.
Also, we use a very simple morel of the labor market: We characterize one wage rate in the market
This implies:
All workers have similar/the same set of skills
All workers have the same disutility for work
In reality, there are fundamental differences between workers and types of jobs…
But, we can keep things simple, and make useful models that help us understand important
relationships and predict what might happen to the labor market when shocks occur.
Also, we just talk about a wage ($/hour of work), but there is no reason why this would mispresent
decisions to work for other types of compensation (salary, benefits).
i.e. $14,720 a year, at 40 hrs/wk and 46 wks/yr is the same as $8/hour
39
9.1 Simple model of the labor market
All firms’ profits are determined by:
Total Cost:

Nominal wage – actual amount paid per unit of work this is price of input ($/labor)

Amount of labor used (Q of input)
Total Revenue

Output produced by a worker productivity of work

Price of output market price ($/unit of output)
What can the firm do to increase their profit?

Depending on competition in the output market, may be able to change price of output

Firms can not change productivity in the short run – but they can change in the long run by
investing in technology

They can change the amount of labor their use

They can change the nominal wage
o
But they need to consider what the employees labor is worth, how to incentivize hard
work, and how to keep employees from quitting (remember what affects this)
Our graph of supply and demand:

Label demand, supply, predicted wage and amt of labor in equilibrium

Y axes: Real wage – (Nominal wage)/CPI
o
CPI – consumer price index

Cost of a standard bundle of goods calculated by the government

Represents cost of living
The CPI represents all goods and services purchased for consumption by the reference
population (U or W). BLS has classified all expenditure items into more than 200 categories,
arranged into eight major groups (food and beverages, housing, apparel,
transportation, medical care, recreation, education and communication, and other
goods and services). Included within these major groups are various government-charged
user fees, such as water and sewerage charges, auto registration fees, and vehicle tolls.
40
Real Wage: What does it tell us…
Minimum wage in California is $13
Minimum wage in Iowa $7.25
Does this mean if you were a worker earning minimum wage you would be x2 as rich if only you
lived in California instead of Iowa?
Lets compare:
Life in Davis, California to life in Ames, Iowa
Rent – one bed room, 600 square feet, cat friendly, ac
$1,600 a month
vs
$700 a month
Dinner – burger with fries and a beer
$30
vs
$19
Gallon of gasoline
$3.29 vs
$1.95
Even though the (nominal) minimum wage is very different in these two places,
It looks like the real wage is probably very similar
When you are deciding how much to work, you are thinking about your real wage because when
you are deciding whether and how much to work, you are considering what the earned income
could get you, which is a function of prices of those goods.
This goes back to this point: We do not get utility from money itself, rather we get utility from
the things that money could buy!
Before we precisely dine the x axis – we need to define a few key terms related to measuring
employment in the economy….
41
9.2
Unemployed individuals:

Individual without work (neither employed formally or self-employed)

Individual who is available for work (not sick, on vacation, etc)

Individual is actively seeking work (taking steps to seek paid employment)
Working age population = Total population – Individuals too old and too young to work
Labor Force = Working age population currently looking and available for work, or currently working
Included both unemployed and employed individuals
Inactive – Working age population that is not employed but also not unemployed.
Includes people who are not looking to work, who are unable to work.
Chart these out in a tree to clarify how they all fit together:
Total
Population
Too young to
work
Working Age
Population
Inactive
Too old to
work
Labor force
Employed
Unemployed
In order to express the state of the economy in terms that are easier to conceptualize or compare to
other economies/over time….
Participation rate = Labor force/working age population
Unemployment rate = unemployed/labor force
Employment Rate = Employed/Working age population
42
9.3 – Model of labor supply with the Wage Setting Curve
Go through HO12 pointing out important things to note:
Model of labor supply, careful to note:
1. Y axis is the real wage
2. X axis is normalized: L/W.A.P.
Explain why: allows us to read important statistics directly from the graph
3. Labor Force line  Participation rate
4. At any real wage, W, expect employment rate L
5. Labor supply will never exceed 1 (which means employed is never larger than labor force)
*careful, cannot directly read unemployment rate...why?
Because the unemployment rate has a denominator = labor force, not W.A.P.
Consider a numerical example to drive this home:
Suppose the total population = 150
# of people of working age = 100
# of people of inactive = 20
# of people active or in labor force = 80
# of people employed (at wage = 7.75) = 50
# of people unemployed (at wage = 7.75) = 30
From this information:
Participation rate = 0.8 (# of active/ W.A.P)
Employment rate = 0.5 (# of employed/ W.A.P)
Unemployment rate = 0.375 (# of unemployed/ active or in labor force)
43
Now, use the model of the labor market to analyze what happens after a shock:
*Review conceptually what the labor force is, and go over examples of what might affect it
Sketch: increase in the number of people actively engaged in the labor market
*Review conceptually what the labor supply is, and go over examples of what might affect it
Sketch: decrease in the WTA (people willing to accept lower wages)
*Review conceptually what the labor force is, and go over examples of what might affect it
Sketch: increase in the demand for workers (firms willing to pay more for work)
Now we will introduce a layer of complexity:
Output market is connected to the labor market
Clarify: Output market = aggregate output = all things produced in an economy
Input

(Labor)
[ Production]
(All Firms)

Output
(All produced goods)
*So suppose there is a positive demand shock in the output market: how does this affect labor market?
 draw the output market change
P increase
Q increase
 how does this change the labor market? Demand for labor increase
W increase
L increase
44
When multiple things happen simultaneously, things get complicated:
For example: The Mariel boatlift (1980) which brought 10,000 Cubans to Miami
What happens to labor markets with an influx of immigrants?
“Immigrants take away American jobs”
When we look at an increase in the labor force, the unemployment rate increases
“Influx of immigrants will lead to decline in wages”
When we look at a positive supply shock, equilibrium wage declines
“Influx of immigrants supports a vibrant economy”
Because more people demand more aggregate output, which increases labor demand
This means wages increase and employment increases
You could use economics to support any of these claims. But of course, the real would is more
complicated. All of these things likely happen simultaneously, and so the outcome depends of the
relative magnitude of each of shocks (and possibly other shocks that we are forgetting to include)


Story one:
o
Small increase in labor force
o
Small increase in supply
o
Large increase in demand
Story two:
o
Small increase in labor force
o
Large increase in supply
o
Small increase in demand
So the “right” prediction of what happens depends on multiple factors…
…but its still worth while to try to model things….because maybe we can outline what we can predict, or
set some parameters to know under what situations we can expect things to happen.
45
9.6 Insights from out modeling of the labor market
* Firms make decisions about quantity produces, labor hired, wages set
* Employees make decision whether to keep or quite job based on their employment rent
* Employment in the economy is the result of responding to a wage set by firms
Unemployment cannot be avoided
Because of asymmetric information  Firms must pay above the employment rent in order to
keep workers and incentivize hard work  Firms’ demand for labor is never going to be as high
as it could be, because they are “over paying” for labor
If you have a job, unemployment is not a bad thing.
It means you earn positive employment rent (better off than you would be if you quit)
It is not a good thing if you do not have a job…because you want to work at the current wage rate, but
cannot find a job.
A thing to note:
Our models of labor in this class have just one skill of worker.
We could try to model multiple levels of works (low and high skill). And then our analysis would
be more complicated….but it might be worth it to make more nuanced observations
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Warm up – review labor market by analyzing the impact of a minimum wage
Make sure to point out demand for labor and supply of labor  Surplus of labor
And connect to rising unemployment
Unit 10: Banks, Money and Credit markets
Now we are going to be studying the market for money
Previously we said that money was not a good…but rather a means to buy goods.
Even though we are now studying the supply and demand for money, it is still true.
The reason why we want money is so that we can buy things or experiences that we really want.
Now, however, we are going to introduce the concept of time.
Money now vs money at some later date (money later)
Basically, what we mean is that we have to balance making purchases now versus making them later
That is, the two goods are: money now and money later
Before diving into the modeling framework…let’s establish some new vocabulary:
10.1 Money and wealth
Borrowing and lending money are about shifting consumption and production over time

Passage of time helps us differentiate between different economic concepts
Money: A medium of exchange consisting of bank notes and bank deposits, or anything else that can be
used to purchase goods and services, and is accepted as payment because others can use it for the same
purpose

Requires trust that the money will be accepted by payment by others
o

This trust is ensured by governments and banks
Distinct from bartering, in which people directly trade goods with one another
Wealth: The value of owned assets minus debt

If you sold everything you owned, how much money would you have?

This is a stock variable
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o
Quantity measured at a point in time
o
Units do not depend on time
Income: Amount of money that you receive over some period of time


Sources
o
Earnings
o
Investments
o
Government
This is a flow variable
o
Quantity measured per unit of time
o
Examples: Annual income, hourly wage
Net income: (Gross) income minus depreciation of wealth

Depreciation: The loss in value of a form of wealth that occurs either through use or the passage
of time
Expenditure: Cost of consumption
Saving: Wealth increase due to expenditures being less than net income

This is distinct from investment such as the purchase of capital goods
(Continue to hand written notes)
Watch Bank Videos
And Complete HO13
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Unit 13: Economic Fluctuations & Unemployment
GDP – measures aggregate output in an economy
Value of all goods & services produced by all individuals and companies
How to measure this (not easily…)
1. Spending/expenditure – by households, firms, governments and residents of other countries
Specifically, expenditures on domestically produced goods & services
2. Production of all businesses that operate in domestic economy
Specifically, calculate value added = value of output – cost of inputs
3. Income – sum all income of individuals and taxes received by the government
Note: Theoretically, income represents value of an individuals’ labor
And theoretically, taxes are used to produce goods and services for the country
All three methods should yield similar estimates…but there are issues with each

How do you value things households consume for free? (clean air, open space, etc.)

What if someone’s income doesn’t represent the full/accurate value of their labor?

How do you measure a service that was provided for free? Do you use the cost of providing it?
Economists measure GDP…refining and updating it
We could use some other indicators of economic health
They mean different things, they all have limitations, and for the sake of time and simplicity, we will
stick to using GDP. If this is something that interests you, you could take development economics!
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Let’s focus/define GDP so we can start looking at theory:
Components of GDP (Y)
Simple model/definition: Y = C + I + G + X – M
C – Consumption of domestic goods and services (individuals and businesses)
I – Investments including capital goods (machinery and equipment), housing/buildings, and
inventory (unsold output produced by firms)
G – government spending including physical things provided (e.g. infrastructure) and services
(teaching at public schools, food stamps, etc)
X – exports which are domestically produced goods and services purchased by people outside
the country
M – imports which are things/services produced outside the country sold to people/firms/gov
inside the country (we do not want to count these…someone else created this value)
Net exports = X – M
 This is how people measure trade balance (difference in value not quantity)
Trade Deficit  X – M < 0
Trade Surplus  X – M > 0
One is not necessarily good. One is not necessarily bad. One might be preferred in
certain situations, but it in and of itself is not a goal.
Reporting GDP is not terribly useful…
In 2019: France’s GDP = $2.6 trillion
Italy GDP = $2.1 trillion
South Africa GDP = $368 billion
What have we learned? What other information might be helpful to tell us about these 4 economies?
(Survey the class)
To improve out ability to use GDP to learn about the economy…we use different stats like

GDP/capita = GDP/total population  allows comparison of countries of very different sizes

GDP/year = % change in GDP btwn years  allows comparison over time
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Handout 14
Country
France
Italy
Singapore
South Africa
China
United States
GDP 2019
$2.6 trillion
$2.1 trillion
$364 billion
$368 billion
$14.3 trillion
$21.4 trillion
GDP/capita
$44,300
$35,600
$58,800
$7,300
$8,300
$55,800
GDP/year
18.2
16.1
7.9
-51
2.7
33.1
Talk about what we can infer about these countries from this information
But remember: Sometimes we need to/want to evaluate very different aspects of an economy
Income inequality
Environmental quality
Living standards
People also like to talk about: (Go over two graphs of gdp growth rate)
Booms – several quarters/years of growth (use annual growth of GDP)
Bust – several quarters/years of decline
 if its “bad enough” then it’s a recession
Note: Business cycles…booms and busts are normal…unless they are not
Economic Shocks and Fluctuations –
While they may be “normal”…they do effect household
To see the connection, consider Okun’s Law – GDP growth is high  unemployment decreases
Recall the connection between the output market and labor market:
Aggregate output = GDP
If aggregate output is increasing  firms are growing  demand for labor increases
The flip is true as well…
If aggregate output is decreasing  firms are shrinking  demand for labor decreases
It is not a direct correlation
GDP is more closely connected to wealth of the owners of a firm (stockholders, investors, etc.)
But there is empirical evidence for the connection btwn peoples’ jobs and gdp
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From Chapter 10, we established that people generally prefer to smooth consumption over time.
What will a household do to help smooth its consumption?

Borrow/lend money

Self-insurance – formally spending money now to protect yourself in the future

Savings – decrease your spending now to protect from future declines in income

Co-insurance – informally spending money to help friends and family (w/ reciprocity in mind)
(solicit examples from the class to break things up a bit)
These will all be effective at protecting an individual household from unexpected fluctuations
But if an entire economy experiences a shock at the same time, a large number of people are affected…
These methods may begin to fail…
Savings might not be enough, people might not be able to support each other, insurance
reimbursements may take a long time.
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Unit 14: Unemployment & Fiscal Policy
We are going to build a simple and more complicated model of the entire economy
This will allow us to more broadly consider the impacts of Fiscal Policy
Fiscal Policy – Government Spending and Taxes used to support economic conditions
(as opposed to Monetary Policy which refers to actions taken by the central bank to control the
supply of money and health of the economy)
We will study the multiplier process – which measures the transmission of shocks through the economy
Critically, the multiplier process depends on the existence of credit constraints which effects
both firms and households
Basically, the constraints mean that households and firms can’t access all the money they want
So when credit constrained households and firms get income, they have a high
propensity to consume it
When firms or individuals make investments, there is:
A direct effect – there literally increase demand for goods/services
And, an indirect effect – there companies/individuals they purchase from get a boost, and
in turn, they will increase investments they make, and so on…
The total impact of the investment = Direct effect + Indirect effect
We will summarize this effect formally:
Multiplier = (Total Impact)/(Size of Change)
<1
= 1  no indirect effect
> 1  positive indirect effect (most common)
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Handout 15 (pages 1-2)
Simple Multiplier Model:
Aggregate demand = AD = C + I
Aggregate Consumption = C = co + c1Y
co = fixed amt people will spend regardless of income (autonomous consumption)
spending on necessities/essentials
c1 marginal propensity to consume = the rate at which consumption changes with income
this is going to be less than 1 … BECAUSE OF CREDIT CONSTRAINTS!
Your income increases…you spend some and save the rest
Remember, this is not a single consumer…it is all consumers added up together
If c1 is close to 0  few households are credit constrained (hh don’t spend what they get)
If c1 is close to 1  many households are credit constrained (hh spend what they get)
(Go over graphs in handout…and discuss graphs from the Economist)
Reminder: Previously we used Y to represent GDP. One of the ways we said we could estimate Y was
through the aggregation of all individuals’ income.
Go over graphics
Now we need to pair a model of aggregate demand (consumption) with a key assumption:
Market Equilibrium aggregate output/production will exactly meet demand
 Y = AD
Remember: We also said that the amount of all goods produced in the economy was equal to GDP or Y
Any point along this 45 degree line is a point of equilibrium.
The Supply of Aggregate Output = Demand of Aggregate Output.
If some shock happens, and knocks you off this line...markets/economic forces…will pull you in
the direction of reaching the line. (We will go over examples of this soon)
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HO15 – page 4
We can develop a mathematical way to define the multiplier in an economy by bringing these two
formulas together.
- work through the math and talk about the role of c1
14.3
We can use our model to evaluate changes in the market:
1
𝑌=(
) ∗ (𝑐𝑜 + 𝐼)
1 − 𝑐1
What are things that could affect our equilibrium?

Consumption patterns could change:
o
MPC could change – credit market changes or changes in preferences

o
Changes the slope
Change in autonomous consumption

Which would be the result of changes in household target wealth, precautionary
savings, necessity expenses

Investment patterns could change:
In HO15 – page 5
Show what happens when there is a sudden decrease in investments
Point out how to see/calc the multiplier:
Direct effect = -20
Total effect = -40
k=2
When the multiplier is greater than 1, the economic impact Is magnified.
When the households are more credit constrained…the magnification is larger
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HO15 – page 6
Next, go over a more complicated model
 This model is necessary because sometimes we want to examine or estimate the impact of another
component of the macro economy
Notice:
We have made a few changes:
Added government expenditures
Added net exports
With m = propensity to import (explain/give an example)
Added income tax
Explain the intuition of the expression
Then derive the new multiplier
Then discuss the types of changes/impacts this new model can examine:
(The things the old model could capture in addition to….)

Changes in government expenditures

Changes in trading patterns/preferences

Changes in income tax
Now lets explore the impact of a Fiscal Policy – Government expenditures
Sketch out example of how government investment might affect GDP
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Unit 15: Inflation, Unemployment and Monetary Policy
14.10 – Aggregate demand and unemployment
Its not all about GDP
That is…GDP was just a way to measure the health of the economy.
It is not a goal in an of itself
And in particular, it can tell us about other things that might be happening in the economy
Like
Household wealth (income)
Labor market conditions (unemployment)
Prices (for things in general)
First lets consider the connection between AD and household wealth
Remember, when output increases, firms need more labor to meet demand
That is, demand for labor increases….which means wages increase
Now go over:
The paradox of thrift: If a household is concerned about hard times ahead, it may adopt thrifty behavior
That is, it will decrease the amount of spending now, and increase their savings…
but this change in consumption in an economy may make their fears come true!
After defining this term… walk through how to model this in steps
Make sure to highlight:

When households experience a large negative economic shock, it makes sense that their
spending behavior changes.

Remember the figures we looked at in HO 15: Since March 2020, households in the united states
have spent less money (they are saving more).

This is completely rational behavior for an individual…but what happens when a large portion of
the population changes their behavior….
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Connection between GDP and Unemployment
In general GDP increase…unemployment decreases and output prices rise
Connection between GDP and Prices
Now prices:
Inflation – general increase in the price of goods in the economy defined over a period of time
Deflation – general decrease in prices
Disinflation – prices are increasing, but at a decreasing rate
Go through examples on Page 3
Why do we care?
The CPI is a macro measure – the economy as a whole
But at the end of the day, we care about people – and people face budget constraints
*Sketch out a decision for purchasing 2 goods with a fixed budget constraint…and what happens when
prices increase…
Who is hurt by inflation?
Pensioners (describe who these people are) – income is fixed even when prices change
Lenders – Set loan arrangement when prices were lower.
When prices increase, the repayment is not worth as much (in real terms)
This means that Borrowers benefit from inflation
They got money when prices were low!
58
Fisher Equation: Real interest rate = nominal interest rate – inflation rate
…measures buying power of the repayment of the loan at the prices that exist when the loan is repaid
For example:
Suppose you take out a loan for $10,000.
You will have to repay the loan in 1 year, and the total repayment will be $10,800.
Additionally, suppose you expect there to be 1.2 % inflation over the next year (i = 0.012)
What is the nominal interest rate? R = P*(1 + r)  r = R/P – 1  r = 10800/10000 – 1 = 0.08
What is the real interest rate?
Real interest rate = nominal interest rate – inflation rate = 0.08 – 0.012 = 0.68
 Because of inflation the loan feels cheaper to the borrower
But it seems less lucrative from the perspective of the lender
If inflation is predictable, no problem, people can logically expect changes in economic conditions, and
adjust their transactions accordingly….
Lenders know some inflation is likely, so they will increase the nominal interest rate
Borrowers know some inflation is likely, so they will be okay with higher nominal interest rates
But problems can arise if inflation is sudden/higher than expected
If the inflation rate in an economy is highly variable or unpredictable,
firms will have a hard time knowing when to invest….
A firm would want to take out a loan when interest rates are low
But if a bank is worried there could be a large amount of inflation…
they will set high nominal interest rates
Firm may not take out a loan/invest in the business
What if an economy was experiencing deflation?
Deflation hurts borrowers, and benefits lenders….why?
If you borrow now, when prices are relatively high…
You will repay when prices are low…and that repayment is more valuable in real terms.
A firm that thinks deflation in the economy is likely may hold out/wait to borrow.
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Inflation:
Is inflation good or bad?
Eh, it depends
Some inflation is considered good….remember is paired with lower unemployment
Too much inflation is bad … if inflation is really high, people don’t want to lend as much money
Deflation is bad too….then people won’t borrow as much money
Where does inflation come from? (Work through models in HO)
Remember the connection between the macro economy models, labor and output markets….
When firms demand more labor….more bargaining power goes to the workers (the workers have what
the firms want)
This means workers can get higher wages
With more income, demand for goods in the economy increase….and output price rises
Remember 3 main causes of inflation:
1. Firms’ power in the output market increases (firms gain price setting power)
2. Employees power in the input market increase (employees can negotiate higher wages)
3. Competition in the input market changes (unemployment decreases)
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So we have seen how inflation (output market prices) is connected to the labor market….
But it is also connected to borrowing and lending markets!
Suppose the central bank increases the base rate…
How does that impact commercial banks?
Inputs (borrowing money from central bank) is more expensive
Negative supply shock
They will increase higher interest rates
How does that impact individuals/small businesses?
Higher prices  demand less money from commercial banks
They will spend less money now
How does this impact the output market?
Few people are buying things
Negative demand shock
Prices decrease  deflation
How does inflation impact the economy? That is, how can we see it impact GDP
In HO 16 illustrate how a predictable inflation rate can affect the economy.
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Watch the Boom and Bust video
Discuss the difference between Keynes and Hayek theories.
Make sure to point out:

Keyenes:
o
To boost inflation and reduce unemployment, governments should stimulate economy
o
Keynes’ theory about macroeconomics is most widely accepted
o
He was critized for supporting peaceful Nazi rule in Germany, but did reverse his opinion
as events progressed, and became an active critique of people who did not do enough
to stop Nazi rule

Hayek:
o
Unemployment is a symptom of a distorted economy. Government intervention forces
inflation and interest rates to misrepresent economic conditions
o
Most of his work deals with looking at prices as signally critical information 
government intervention prevents the true signals from being sent
o
Most economists like his theories about prices…but reject his macroeconomic theory
o
He was more universally considered to be racist/antisemitic.
*They both carried out work that had a great influence on economics. I do not want to suggest they
were good people on every dimension.
Review:
GDP increase is associated with an increase in employment (decrease in unemployment)
GDP increase is associated with an increase in household wealth
GDP increase is associated with inflation
Lower interest rates lead to inflation (Higher interest rates lead to deflation or disinflation)
Recap
Inflation or the change in prices can tell us a lot about what is happening in an economy:

Inflation is associated with ________________________ in unemployment
o

Which means it is also associated with _________________________ in employment
Inflation is associated with __________________________ in interest rates (set by central bank)
o
Which means it is also associated with ___________________________ base rate
62