Finish Our Review of Intermediate
Micro and Hit Some High Points of
Empirical Policy Analysis

Outline

Finish Review of Intermediate Micro


Chapter 2: elasticity, the supply curve, market
demand and supply, equilibrium, and welfare
(consumer and producer surplus).
Empirical Policy Analysis

Chapters 3 and 4.


Correlation versus causation.
 Experiments, time series studies, cross-sectional
studies, quasi experiments.
Budgeting

Present value
EQUILIBRIUM AND SOCIAL
WELFARE: Elasticity of demand

A key feature of demand analysis is the elasticity
of demand. It is defined as:
QD
D 


P
That is, the percent change in quantity demanded
divided by the percent change in price.
Demand elasticities are:



P
QD
Typically negative numbers.
Not constant along the demand curve (for a linear demand
curve).
It is easy to define other elasticities (income, crossprice, etc.).
EQUILIBRIUM AND SOCIAL
WELFARE: Supply curves



We do a similar drill on the supply side of the
market. Firms have a production technology (we
might write it as)
QM  f  LM , K M 
We can construct isoquants, which represent the
ability to trade off inputs, fixing the level of output.
The isocost function represents the combinations of
various inputs, where total costs are fixed.

Firms maximize profit (minimize cost) when the marginal
rate of technical substitution equals the input price ratio.

Also MR=MC at the profit-maximizing level of output.
EQUILIBRIUM AND SOCIAL WELFARE
Equilibrium


In equilibrium, we horizontally sum individual
demand curves to get aggregate demand.
We also horizontally sum individual supply curves to
get aggregate supply.



A firm’s supply curve is the MC curve above minimum
average variable cost.
Competitive equilibrium represents the point at
which both consumers and suppliers are satisfied
with the price/quantity combination.
Figure 21 illustrates this.
PM
Intersection of supply and
demand is equilibrium.
Supply
curve of
movies
PM,3
PM,2
PM,1
Demand
curve for
movies
QM,3
Figure 21
QM,2
QM,1
Equilibrium with Supply and Demand
QM
EQUILIBRIUM AND SOCIAL
WELFARE: Social efficiency




Measuring social efficiency is computing the potential
size of the economic pie. It represents the net gain
from trade to consumers and producers.
Consumer surplus is the benefit that consumers
derive from a good, beyond what they paid for it.
Each point on the demand curve represents a
“willingness-to-pay” for that quantity.
Figure 22 illustrates this.
PM
The Yet
The
consumer’s
the
willingness-to-pay
actual“surplus”
price paid
from
for
is
Supply
the first
the first
unit
much
unit
is this
is
lower.
very
trapezoid.
high.
curve of
The There
willingness
is stilltosurplus,
pay for the
movies
The
consumer’s
“surplus”
from
because
second unit
the is
price
a bitislower.
lower.
the next unit is this trapezoid.
The
The consumer
total consumer
surplus
surplus
at Q* is
is
the area this
between
triangle.
the demand
curve and market price.
P*
Demand
curve for
movies
0
Figure 22
1
2
Q*
Deriving Consumer Surplus
QM
EQUILIBRIUM AND SOCIAL
WELFARE: Social efficiency

Producer surplus is the benefit derived by

producers from the sale of a unit above and
beyond their cost of producing it.
Each point on the supply curve represents
the marginal cost of producing it.
Figure 24 illustrates this.

PM
Supply
curve of
movies
The producers
total producer’s
surplus
surplus
at Q* is
the area this
between
triangle.
the demand
curve and market price.
P*
There
The
marginal
is producer
costsurplus,
for from
the
The
producer’s
“surplus”
because
second
unit
the
price
a bit
ishigher.
higher.
the
next unit
is is
this
trapezoid.
The producer’s
TheYet
marginal
the actual
“surplus”
costprice
forfrom
the
the first
received
first
unitunit
isisthis
is
much
very
trapezoid.
higher.
low.
0
Figure 24
1
2
Producer Surplus
Q*
Demand
curve for
movies
QM
EQUILIBRIUM AND SOCIAL
WELFARE: Social efficiency


The total social surplus, also known as
“social efficiency,” is the sum of the
consumer’s and producer’s surplus.
Figure 25 illustrates this.
PM
The
Providing
surplus the
from
first
theunit
next
Supply
gives
unit isathe
great
difference
deal of
curve of
between
surplus
the
to demand
“society.”and
movies
supply curves.
Social
The area
efficiency
between
is maximized
the supplyat
*, and iscurves
and Q
demand
the sum
from
of the
zero to
consumer
Q* represents
and producer
the surplus.
surplus.
P*
This area represents the
social surplus from
producing the first unit.
0
Figure 25
1
Social Surplus
Q*
Demand
curve for
movies
QM
EQUILIBRIUM AND SOCIAL
WELFARE: Competitive equilibrium maximizes
social efficiency




The First Fundamental Theorem of
Welfare Economics states that the
competitive equilibrium, where supply equals
demand, maximizes social efficiency.
Any quantity other than Q* reduces social
efficiency, or the size of the “economic pie.”
Consider restricting the price of the good to
P´<P*.
Figure 26 illustrates this.
PM
This triangle represents
lost surplus to society,
known as “deadweight
loss.”
The With
socialsuch
surplus
a price
from Q’
is restriction,
this area, consisting
the quantity
of a
´, and there
falls
larger
to Q
consumer
andis
smaller
excess
producer
demand.
surplus.
P*
Supply
curve of
movies
P´
Demand
curve for
movies
Q´
Figure 26
Q*
Deadweight Loss from a Price Floor
QM
EQUILIBRIUM AND SOCIAL
WELFARE: The role of equity




Societies usually care not only about how
much surplus there is, but also about how it is
distributed among the population.
Social welfare is determined by both criteria.
The Second Fundamental Theorem of
Welfare Economics states that society can
attain any efficient outcome by a suitable
redistribution of resources and free trade.
In reality, society often faces an equityefficiency tradeoff.
EQUILIBRIUM AND SOCIAL WELFARE
The role of equity


Society’s tradeoffs of equity and efficiency
are models with a Social Welfare Function.
This maps individual utilities into an overall
social utility function.
EQUILIBRIUM AND SOCIAL WELFARE
The role of equity

The utilitarian social welfare function is:
SWF 
U
i
i


The utilities of all individuals are given equal
weight.
Implies that government should transfer from
person 1 to person 2 as long as person 2’s gain is
bigger than person 1’s loss in utility.
EQUILIBRIUM AND SOCIAL WELFARE
The role of equity

Utilitarian SWF is maximized when the
marginal utilities of everyone are equal:
MU1  MU 2 ...  MU i

Thus, society should redistribute from rich to
poor if the marginal utility of the next dollar
is higher to the poor person than to the rich
person.
EQUILIBRIUM AND SOCIAL WELFARE
The role of equity

The Rawlsian social welfare function is:
SWF  minU1 , U 2 ,..., U N 


Societal welfare is maximized by maximizing
the well-being of the worst-off person in
society.
Generally suggests more redistribution than
the utilitarian SWF.
Chapter 3: Empirical Approaches to
Policy Analysis


Empirical public finance is the use of data and
statistical methodologies to measure the impact of
government policy on individuals and markets.
Key issue in empirical public finance is separating
causation from correlation.


Correlated means that two economic variables move
together.
Casual means that one of the variables is causing the
movement in the other.
THE IMPORTANT DISTINCTION
BETWEEN CORRELATION AND
CAUSATION

One interesting, tragic example given in the
book describes some Russian peasants.




There was a cholera epidemic. Government sent
doctors to the worst-affected areas to help.
Peasants observed that in areas with lots of
doctors, there was lots of cholera.
Peasants concluded doctors were making things
worse.
Based on this insight, they murdered the doctors.
The Problem

In the Russian peasant example, the
possibilities might be:



Doctors cause peasants to die from cholera
through incompetent treatment.
Higher incidence of illness caused more
physicians to be present.
Peasants thought the first possibility was
correct.
MEASURING CAUSATION WITH DATA
WE’D LIKE TO HAVE: RANDOMIZED
TRIALS


Randomized trials are one often effective way of
assessing causality.
Trials typically proceed by taking a group of
volunteers and randomly assigning them to either a
“treatment” group that gets the intervention, or a
“control” group that is denied the intervention.


With random assignment, the assignment of the
intervention is not determined by anything about the
subjects.
As a result, with large enough sample sizes, the treatment
group is identical to the control group in every facet but
one: the treatment group gets the intervention.
The Problem of Bias

Bias represents differences between treatment
and control groups that is correlated with the
treatment, but not due to the treatment.


An example of bias: in 1988 the SAT scores of
Harvard applicants who took test preparation courses
were lower than those of students who did not. This
would bias straightforward effort to study the effects
of SAT classes on test scores.
By definition, such differences do not exist in a
randomized trial, since the groups, if large
enough, are not different in any consistent fashion.
Why We Need to Go Beyond Randomized
Trials

Randomized trials present some problems:





They can be expensive.
They can take a long time to complete.
They may raise ethical issues (especially in the
context of medical treatments).
The inferences from them may not generalize to
the population as a whole.
Subjects may drop out of the experiment for
non-random reasons, a problem known as
attrition.
Time Series Analysis

Time series analysis documents the
correlation between the variables of interest
over time.


It is difficult to identify causal effects when there
are slow moving trends and other factors are
changing.
Sharp changes in a policy variable over time, may
create opportunities for valid inference.
Figure 2
Cross-Sectional Regression Analysis




Cross-sectional regression analysis is a statistical
method for assessing the relationship between two
variables while holding other factors constant.
“Cross-sectional” means comparing many individuals
at one point in time.
An example: HOURS    TANF  CONTROL  
Where the control variables account for race,
education, age, and location
i
i
i
i
Quasi-Experiments


Economists typically cannot set up randomized trials
for many public policy discussions. Yet, the timeseries and cross-sectional approaches are often
unsatisfactory.
Quasi-experiments are changes in the economic
environment that create roughly identical treatment
and control groups for studying the effect of that
environmental change.

This allows researchers to take advantage of
randomization created by external forces.
An Example of a QuasiExperiment

New Jersey raises their state minimum wage.
Pennsylvania does not.

We are interested in the effect of the minimum wage on
employment.

We could look at the employment of low-skilled workers in NJ
before and after the minimum wage increase.



But other things in the economy might be occurring.
So, we can see how employment changed in PN over the same
interval.
The difference in employment in NJ, before and after,
compared to the difference in employment in PN, before
and after, may reveal the causal effect of minimum wages
changes, if NJ and PN are identical (similar?) in other
respects.
Structural Modeling

Both randomized trials and quasi-experiments suffer
from two drawbacks:


First, they only provide an estimate of the causal impact
of a particular treatment. It is difficult to extrapolate
beyond the changes in policy.
Second, the approaches often do not tell us why the
outcomes change. For example, the approaches do not
separate out income and substitution effects in the TANF
example used in the book.

Structural estimation attempt to estimate the underlying
parameters of the utility function.
A Couple Items About Federal
Budgets

Government debt is the amount that a
government owes to others who have loaned
it money.


It is a stock variable; the debt is an amount owed
at any point in time.
Government deficit is the amount by which
spending exceeds revenues in a given year.

It is a flow variable; the deficit flow is added to the
previous year’s debt stock to produce a new stock
of debt owed.
Real vs. Nominal


The debt and deficit are often expressed in nominal
values–that is, in today’s dollars.
Inflation changes the real value of the debt or deficit,
however, because prices change.


The consumer price index (CPI) measures the cost of
purchasing a typical bundle of goods. It increased 91% between
1982 and 2003.
Inflation reduces the burden of the debt, as long as that debt is a
nominal obligation to borrowers.


Rising prices leads to what is known as the “inflation tax” on the holders
of the debt–the payments are worth less because of rising prices.
In 2003, the national debt was $3.91 trillion and inflation was 1.9%. The
inflation tax was therefore $74 billion, which would reduce the
conventionally measured deficit from $375 billion to $301 billion.
Background: Present Discounted Value




To understand budgeting, you must
understand the concept of present discounted
value (PDV).
Receiving a dollar in the future is worth less
than receiving it today, because you have
foregone the opportunity to earn interest.
PDV takes future payments and expresses
them in today’s dollars.
It does so by discounting payments in some
future period by the interest rate.
Background: Present Discounted Value

A stream of payments would be discounted as:
B1
B2
Bt


...

2
t
1

r
  1  r 
1  r 
Where B0 through Bt represent a stream of benefit
obligations, r is the interest rate, and t is the number of
periods.
PDV  B0 


For example, $1,000 received 7 years from now is only worth $513
with a 10% interest rate:
51316
. 

1000
. 
1  010
7

1000
1948
.
A constant payment received indefinitely has the PDV=P/r