Economics Lectures PDF

-​ cooperate, but punish defections and return to inice LECTURE 1 content: -​ economics is the study of incentives -​ growth, development and inequality -​ gdp as a measurement of the economy -​ capitalism as a combination of property, firm...

-​ cooperate, but punish defections and return to inice LECTURE 1 content: -​ economics is the study of incentives -​ growth, development and inequality -​ gdp as a measurement of the economy -​ capitalism as a combination of property, firms, and markets economics vs politics -​ economics studies how incentives drive behaviour -choosing outcomes that improve material welfare -​ unlike politics: power drives behaviour -to determine who gets what -​ overlap is in institutions shaping cost/benefit of behaviour: -rules established through politics (including tax and spending) what economic outcomes? -​ the study of individual incentives and behaviour is usually referred to as microeconomics -​ the incentives faced by billions of individuals and millions of firms leads to aggregate outcomes -economic growth and development -economic crises -inflation and unemployment -inequality and affordability -​ the study of entire economy, as aggregate outcomes is generally referred to as macroeconomics -we cover this in the second part of the course -business cycles and gov response -consumption, investment -monetary and fiscal policy economics and incentives -​ australia was a destination for british convicts -​ ship captains were paid for each felon they transported to australia -​ due to poor conditions many would die ( aprox. ⅓) on the way so new incentvie was the bring them alive back  -​ cooperate, but punish defections and return to inice -​ regulations and public appeals failed -captains were paid for each prisoner that boarded a ship -until, one economist suggest new incentives -the captains gave the money back for each convict -​ ff to 2021 -​ you’re in government looking to recover from a crippling pandemic !!! missing info the course: public policy approach -​ economics starts with models. here also, but then: -pathway 1: advanced math and extended formal logic -pathway 2: institutions and public policy -​ focus on backround and diagrams in the book -use clickable graphs -​ public policies presented in class are notable examples (exam!!) -​ exam: 100%: 70% multiple choice; 30% short answer questions (graph reading, shorter answer) measuring the economy nominal gdp (gdp growth) -​ gross domestic product measured in current currency amount -​ does not account for inflation or differences in purchasing power across countries -​ simply refers to the “sticker price” real gdp (gdp growth) (in constant prices) -​ important for measuring changes over time -​ growth adjusted for changes in inflation -​ we translate current nominal prices to a consistent baseline -​ applies to any type of price measure -movie ticket sales -stock market prices purchasing power parity -​ important for measuring changes across countries and time -​ growth adjusted for differences in currencies and what those currencies purchase -​ generally we translate local economic activity in to its equivalent in us dollars of a particular year  -​ cooperate, but punish defections and return to inice nominal vs. constant prices top 5 movies based on nominal: -star wars: the force awakens (936 m) -avengers -avatar … constant: -gone with the wind (1939) -srar war (episode IV) what does gdp measure? -​ gdp measures the market value of all finished goods within a country (usually measured yearly) -​ finished goods: goods that will not be sold again as part of another good -​ intermediate goods: foods that will be used to make sth else that will be sold -​ capital goods: goods that are used to produce other goods not a part of other goods -​ measured by government statiscians -​ measures the market value of all finished goods produced within a country (usually measured yearly) -​ does not include things that are imported from other countries -stuff made in another country and sent here3 -​ does include things exported to other countries -export incomes GDP = consumer spending (finished goods) + investment (in capital goods) + government spending (on finished goods) + (exports-imports) Y= C+I+G+ (X-M) (x-m)- often seen as “NX” or “next exports” GDP per capita  -​ cooperate, but punish defections and return to inice -​ interested in how big an economy is = what GDP tells us -​ but also often interested in how wealthy a country is -​ we can use GDP tell us this by dividing the gdp by the total population -​ gdp/population Where does Economic Growth come from? increases in… -​ natural resource discovery -​ physical capital or infrastructure -​ population -​ human capital -​ technology -​ law short term causes: -​ positive shocks -​ negative external shocks -​ governments monetary or fiscal policy -​ consumer/ business sentiment Wealth and Health of Nations: “... but gdp only measures material values, i care about development” but is a good indicator of “development” because it is correlated with many things we care about like: health and happiness GDP does have one or more major faults -it doesnt say much about inequality- the distribution of income within a country -historically gdp growth correlates with growth in everyone’s income inequality over time -1000 years ago, the world was “flat”: small differences between countries -1980: The poorest countries (dark red) were lesotho and china. the richest (dark green) were switz. finland and the US -”skyscrapers” have increased over time: difference between the richest 10% abd the rest -​ cooperate, but punish defections and return to inice local and global inequality -​ why are some countries rich and others poor? -​ why are some people in a country rich, while others in the same country are poor? -​ part of the answer is economic (technology and capitalism) -​ part of the answer is political (democracy and property right -​ we know a lot but we still dont have complete answers to these questions economic systems -​ the explosion in growth rates correlates with development of different economic systems -​ other types of systems… -feudal -communist -mercantilist (statist) -​ we should keep in mind… -there are no pure economic systems -in reality, most economic systems are a mix with more or less of different components of each (varieties of capitalism) -creating labels makes it easier to talk about the increase in economic growth likely starts with capitalism… -​ capitalism: economic system in which private property, markets, and firms play an important role; economic system based on individualism and economic incentives 3 elements of capitalism -​ private property: -people can keep the gains of the labor and are protected from the governments and other trying to confiscate it -they can also own capital goods -​ markets -allocation of goods and services are determined by buying and selling, not governments  -​ cooperate, but punish defections and return to inice -​ firms (privately run and organized) -business organization which pays wages and salaries to employ people and purchases inputs to produce and market goods and services with the intention of making a profit limited liability: if company bankrupt, people can only sue in order to get their contracts/rights back adam smith in the wealth of nations (1776) -advocate of trade but also of capitalist economy …a businessman intends only his own gain and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. nor is it always the worse for the society that it was no part of it. by pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it incentives and economic organization -​ If you keep the gains of your labor, what will you choose to do? -​ work in a job in which you are mediocre or poor at? (poorly compensated) -​ or work doing something you are good at? (you are well compensated) -​ this leads to specialization and the division of labor What does capitalism give us? -​ division of labor -​ specialization -​ entrepreneurial investors -​ new technology self sufficiency is the road to poverty -no one is likely to be good at everything -think about how you ate breakfast this morning. did you do this on your own? no -at every step of the way, there was someone specializing in a particular elements +​ the pig and wheat farmer +​ bacon smoke house +​ dairy farmer +​ logistics/shipping company that got the products to you  -​ cooperate, but punish defections and return to inice specialization: this takes place when an individual, country or some other entity produces a more narrow range of goods and services than it consumes, acquiring the goods and services that it does not produce by trade division of labor: specialization of producers to carry out different tasks in the production process technological innovation -technological innovation is clearly tied to improving economies and improving living standards. -where does technological innovation come from? -why would you invent a new product? -to make the world a better place? -to impress your friends? -to make a cold hard cash? incentives matter incentives >>> “innovationism” -​ innovations cause rapid growth expansion -​ creating more with the same stuff -​ usually mark this with the emergence of the industrial revolution capitalism, democracy, and property -​ many places we refer to as capitalist aren't really capitalist -​ they might lack: secure property rights and other stuff.. -​ how do we ensure secure property rights? -and competitive markets? -​ political institutions are the key democracy and property rights -​ democracy has many definitions, but generally includes +gives equal political power to all citizens +selects political leaders by means of election: in these elections, virtually all adults are eligible to vote and the governing party leaves office -​ individuals generally opt to secure property rights and compete in the market if they can choose their economic system  -​ cooperate, but punish defections and return to inice political institutions and inequality -political institutions can also -determine who benefits from markets and has access to them -help address inequalities that arise as a result of capitalism examples: -​ social welfare systems -​ employee rights (for gig economy workers) -​ consumer protection (anti-monopoly and price-gouging regulations -​ trade protection for industry -​ politics can also be regressive (hurting) -​ big business can exploit, repress citizens together with state -​ does democracy restrain negative tendencies take away -​ economics is about incentives -​ measuring economic size and growth -​ economic growth is not given in economic history -​ only arises under specific circumstances -​ the story i told suggests that capitalism and democracy are conductive to growth LECTURE 2 STRATEGIC INTERACTION: GAME THEORY today’s content: SOCIAL DILEMMAS, INCENTIVES AND STRATEGIC INTERACTION games as analytical devices for situational awareness and strategy enhanced cooperation strategies SOCIAL DILEMMAS, STRATEGIC INTERACTION -economic actors do not act in isolation -we have to deal with other people  -​ cooperate, but punish defections and return to inice -this produces opportunity (gains) and conflict (losses) -game theory provides a framework to understand these interactions social dilemmas: negative outcomes, despite incentives to cooperate -​ actions take independently by self interested individuals => situations where we have suboptimal outcomes e.g. traffic jams, climate change 3 kinds of social dilemmas: 1.public goods -​ are non-excludable -​ once they are supplied, anyone can consume for free -​ non-rival goods: consuming the good does not reduce supply for others -​ utilities, lighthouses, as examples -​ pronte to free riding: -​ benefiting from the contributions of others without contributing oneself -​ solution is typically public provision and payment (taxes) -​ since incentives inhibit cooperation 2.tragedy of the commons -​ common-pool resources: -resources shared by groups -sustainability requires restraint from all group members -​ free riding is the key problem: -if you reduce carbon footprint … you will bear the costs -others who don't will enjoy the benefits, until the resource is entirely depleted 3.joint goods -​ joint goods: private goods enjoyed by actors only if they can cooperate in companies, management and employees need each other -​ cooperate or fight over share of company income, working hours and conditions -​ distribution of cooperation benefits is the main problem -​ power struggle over distribution common -​ concrete issue game theory: core concepts  -​ cooperate, but punish defections and return to inice -game theory is an analytical tool and method (not a theory) -assumed individuals are rational and act strategically -why dont actors always reach agreements? which outcomes are more probable? -​ social interaction: each actor’s behaviour affects everyone’s outcomes -​ strategic interaction: each actor is aware of how their behaviour affects everyone’s outcomes, may involve communication or not -​ strategy: -​ actions taken that consider the outcomes and likely behaviour of others -​ best choice considering others’ action elements of the game: players- who is involved feasible strategies- possible actions information- what each player knows when choosing their action payoffs- outcomes for every possible combination of actions game types: invisible hand: actors maximise benefits without any real/complicated strategy (adam smith, division of labour/trade); win-win situation can evolve; prisoner’s dilemma: introduces negative consequences for cooperation, actors experience pressure to not cooperate, even though benefits are high; coordination: -actors choose strategy closest to preferences, given constraints of what another actor does, poor information on intent -tragedy of the commons: -cooperation without government? in many situation we can, many economists if government medicine is worse than disease; in the attempt to stop the problem, does including it makes it worse invisible hand -anil and bala EXAMPLE => payoff matrix= a table of payoffs associated with every possible combination of strategies chosen by two or more players in the game; understanding of the economic benefits from choosing one thing -​ cooperate, but punish defections and return to inice BEST RESPONSE -strategy that will give a player the highest payoff, given the strategies that the other players select -sticking to what each player is the best at and not going for other options DOMINANT STRATEGY -action that yields the highest payoffs for a player, no matter what the other player does -anil’s payoffs are highest by growing cassava, regardless what bala does-this is his dominant strategy DOMINANT STRATEGY EQUILIBRUM -an outcome of a game in which every player plays his or her dominant strategy equilibrium (in general): self-perpetuating situation. a state or outcome does not change unless outside forces changes -​ better prices(high price) +1 payoff!! when anil and bala each play their dominant strategy, the outcome is (cassava, rice) THE INVISIBLE HAND -​ pursuit of self interest can lead] -​ to outcomes that are socially desirable -​ complementary self-interests coupled with specialization -​ each player got the best of the four possible outcomes/payoffs -​ total payoffs combined higher (society is a winner) PROBLEMS: - sometimes following your self interest can lead to: - suboptimal outcomes (underperformance) -really bad outcomes (climate change) -negative externalities (bad outcomes for others) what if there are downsides to what others do? -​ cooperate, but punish defections and return to inice -how does strategic interaction change? THE PRISONER’S DILEMMA: incentives undermining cooperation -​ two criminals are caught: there is not enough evidence to convict them of an entire crime -​ the government offers both the same deal +snitch on the other and get off free +if you both snitch you get 5 years +if you remain silent you get 20 years if your partner snitches +if both remain silent, light 1 year sentence “the most optimal option for both is to shut the fuck up” -​ colelctively, both would choose to remain silent -​ each has an incentive to defect (or snitch on) his accomplice -​ nash equilibrium: they all have the incentive to snitch lesson: -individual incentives often make cooperation difficult -selfish behavior can lead to suboptimal outcomes COORDINATION GAME: PESTICIDES AND SUSTAINABILITY equilibrum -​ given weak cooperation expectations, is the dominant strategy equilibrium -​ both farmers choose this (2/2 payoff) -​ boyh farmers would be better off collectively using IPC instead -​ no weak commitment TRAGEDY OF THE COMMONS -​ tragedy of the commons concerns common property goods. -goods are rival in consumption and non-excludable (to the group) -unchecked behavior leads to overexploitation -​ not everything on the earth is easily owned -water -air -public lands -​ several cow herders live near a common area used for grazing -common resources, but rival incentives -elinor ostrom (nobel economics prize): need for institutions:  -​ cooperate, but punish defections and return to inice -farmers can create rules and transparency to support credible commitments -requires good information and willingness to exclude or sanction the defector -solution: making commons excludable -people on the spot better at decisions than bureaucrats or politicians NASH EQUILIBRIA AS MOST LIKELY OUTCOMES -each player’s strategy is a best response to the strategies chosen by everyone else -for example, your best response of which side to drive will depend on what the others choose to do -nash equilibrium: a set of strategies, one for each player in the game, such that each player’s strategy is a best response to the strategies chosen by everyone else -actors avoid other choices, leading to outcomes -choice depends on what others do CONFLICTS OVER WHICH EQUILIBRIUM WILL OCCUR -​ there may be mutual gains to getting to one or the other of these equilibria, but who gets the lion’s share of these gains may differ among the outcomes example: -​ two software engineers both do better if they work in the same language -​ astrid does better if the language is java, while the reverse is true for bettina -​ two nash equilibria: both choose java or both choose C++ CONFLICTS OVER CLIMATE PROTECTION EFFORTS - worst outcome for both countries is that both persist with BAU, running a significant risk of human extinction - best for each is to continue with BAU and let the other one restrict CONFLICTS OVER CLIMATE PROTECTION EFFORTS -​ two nash equilibria: actors differ on which country bears the cost of restricting emissions -​ these two nash equilibria are such that two players adopt different strategies -​ negotiations are bound to be difficult, since each country would prefer the other to take the lead on restricting carbon emissions -​ so: no one wants to see catastrophic climate change, but neither wants to lose to the other and adjust first, or adjust more  -​ cooperate, but punish defections and return to inice JOINT GOODS AND STRIKING WORKERS -​ strikers or lockouts as failed cooperation= -lost income for workers and company -reduces GDP (sometimes in the broader economy) -​ Wage coordination mechanisms can help avoid but not eliminate conflict -​ businesses and unions may hate the idea of cooperating with the enemy and fight -​ coordination designed to promote negotiation JOINT GOODS EXAMPLE: BOEING WORKERS STRIKING -strikes hurt workers and company -cooperation best for both (fair wages) -company could win concessions to serve shareholders, not workers -union would win concessions to serve workers, not shareholders BARGAINING TO RESOLVE PROBLEMS -when we confront these problems in economics, political science, or IR -​ hard bargaining -availability of alternatives decreases need to accept unattractive terms -BATNA: best alternative to a negotiated agreement -sometimes a skewed nash equilibrium outcome -what if bargaining includes mechanisms to xtend bargaining results into the future? -​ creating a credible commitment (institutions and enforcement) -​ this can support the ideal compromise scenario -​ or enforce a one sided negotiation outcome -​ examples: -​ wage coordination mechanisms and tribunals -​ trade agreements REPEATED GAMES -​ incentive for long term benefits -​ repeated interactions due to social norms, reciprocity and peer punishment -​ behaving selfishly in one period has consequence sin future periods -​ copycat behaviour works best:  -​ cooperate, but punish defections and return to inice TOOLKIT TO OVERCOME SOCIAL DILEMMAS repeated interaction: -​ collective payoffs increase through long term cooperation -​ selective punishments against cheaters can correct behaviour (tit for tat retaliation) fewer number of players: -​ easier for cooperation to emerge when there are few actors -​ in collective action problems to cost of individual defection are high -​ it is easier to monitor defection in repeated interaction monitoring enforcement and institutions (“see you in court!”) -​ set guidelines or rules, monitor compliance and strengthen commitments -​ transparence -​ everyone gets confirmation that others follow the rules social norms and persuasion (“see you soon!”) -​ norms of fairness, appropriateness of actor behaviour PSYCHOLOGICAL BIAS AND GAME THEORY GAPS -people do not meet high standards of perfectly rationality -imperfect information and cognition -ability to process costs/benefits rationally and biases: -loss aversion- hold value of potential losses face or status -discounting behavior- care less about future gains/ losses/ threats (see climate change, government debt, what your vote will mean) -behavioral economics is dedicated to impact -social preferences: some people might care what happens to others -​ even at personal cost -​ altruism: benefiting others for greater good -​ empathy takeaways: 1.social dilemmas are sub-optimal outcomes in the absence of governments 2.game theory help us model strategic interactions -​ social interactions: actors seek gains but may conflict over distributing payoffs -​ based on incentives and absence of trust -invisible hand, prisoner’s dilemma, coordination poblems next class: public policy options  -​ cooperate, but punish defections and return to inice LECTURE 3 today: -​ public policy purposes functional: market and cooperation failure normative: societal -​ games, efficiency and norms -​ public policy tools -​ achieving results, or chasing cats? Public Policy Purposes Functional Reasons ​ What it means: The government steps in to make things work better without needing to debate what’s morally right or wrong. ​ Why: To improve efficiency and ensure the system runs smoothly. Correcting Cooperation Failure ​ What it means: Sometimes businesses don’t work together even when cooperation would benefit everyone. ​ Why: If companies worked together, they could produce more or create better services. An example is the “pest game,” where farmers could team up to control pests but don’t, causing lower crop yields. Correcting Market Failure ​ What it means: Sometimes the market fails to provide products people need, even when there’s demand. ​ Why: ○​ The market might be too small for a company to profit (like treatments for rare diseases). ○​ Companies might secretly agree to keep a product off the market or limit production to keep prices high. -WWYD normative reasons: societal demands -fairness/inclusion/sustainability is the object -voting population changes -new voters expect the state to shape the market or compete with it -working class right to vote (~1918)precedes labour rights (1930s)  -​ cooperate, but punish defections and return to inice -women’s right to vote (~1920) precedes welfare and healthcare -​ value (changes) -equality/fairness/env issues -vary depending on where you are: resulting in public policy variance women get the vote -> elected officials vote for new gov spending -> effects on child health programs GAMES, EFFICIENCY AND NORMS Fairness approaches: Substantive/Allocation (Quantitative) ​ What it means: This looks at how money, wealth, and resources are distributed in society. ​ Key Questions: ○​ Is wealth and income shared fairly, or is it concentrated in the hands of a few? ○​ Does the way wealth is distributed help or hurt the economy? For example, if too much money is held by the rich, fewer people might be able to spend on goods and services, slowing economic activity. 2. Procedural/Normative (Appropriateness) ​ What it means: This focuses on whether the process of distributing wealth and opportunities is fair and just. ​ Key Questions: ○​ Do people have equal chances to succeed regardless of where they come from? ○​ Are people treated unfairly based on class, gender, race, or religion? For example, if certain groups are excluded from jobs or education, the system is not fair. procedural/normative fairness rules of the game that treat folks (in)appropriately: -​ voluntary exchange of private property acquired by legitimate means -​ equal opportunity for economic advantage? or discrimination? -​ deservingness: did the rules take account of the extent to which individuals need, or deserve, the amounts they get? do they need help to have a fair change at success?  -​ cooperate, but punish defections and return to inice The Rawlsian Veil of Ignorance is a way to think about fairness: 1.​ Fairness for Everyone: Assume rules should be fair to all. 2.​ Imagine You Don’t Know Your Role: Pretend you don’t know your social status, wealth, or background. 3.​ Make Fair Decisions: From this neutral perspective, decide what rules would be just. Example: If you were designing a country’s laws without knowing if you’d be rich or poor, you’d likely choose fair laws that protect everyone equally. It’s like following the Golden Rule: “Treat others the way you want to be treated.” public policy and fairness expectations 1. Classic Left-Right Cleavages: ​ High Taxes for Social Benefits: ○​ Left: Support high taxes for fairness and social welfare. ○​ Right: Oppose high taxes, value hard work and keeping earnings. ​ Cutting Environmental Protections: ○​ Left: Protect the environment, even if costly. ○​ Right: Cut protections to boost the economy. 2. New Cleavage: Economic Nationalism ​ For: Protect local jobs and industries through trade limits. ​ Against: Support free trade and global cooperation. combined reasons: -​ markets often work better (efficiency) when inclusive -mass production, consumption, employment support growth -and resilience (ability to withstand shocks) -domination by big business can also choke off market entry -desire to be good but also desire to make market stronger -both allocation and fairness -​ parliamentary train example (1844-): -uk gov grants concessions to build train network -but later demands one train a day at affordable prices -enabling more consumer use, business access for economy -​ data roaming example (EU 2017-) -​ cooperate, but punish defections and return to inice -national phone companies charge high fees to use data abroad -EU demands data roaming included in home data plans -enabling more consumer use -larger digital economy -​ digital divide (broadband and computer access) -offering more inclusion by providing access in institutions Public Policy Tools (Simple Explanation): 1.​ Tax and Redistribute ○​ The government collects taxes and uses the money for public services like healthcare, housing, and childcare. ○​ It also offers incentives to encourage good behavior (e.g., tax breaks for eco-friendly businesses). 2.​ Command and Control Regulation ○​ The government sets rules to control the market, like protecting inventions (patents) or preventing monopolies (anti-trust laws). ○​ It also regulates the job market with labor laws. 3.​ Information and Persuasion ○​ The government educates people on what’s beneficial (e.g., recycling campaigns). ○​ It also promotes good behavior through social norms and expectations. Games, Efficiency, and Norms (Simple Explanation): ​ Economics aims for efficient outcomes where society as a whole benefits, even if gains aren’t shared equally. ​ Game Example: Tragedy of the Commons ○​ Problem: If land is shared (common property), too many cows may be grazed, ruining the land. ○​ Solution 1: Private Property: One farmer owning the land prevents overgrazing (efficient) but may seem unfair. ○​ Solution 2: Shared Responsibility: If farmers cooperate, land can be used fairly and sustainably. -(this is how england moved peasants off the land to increase wool production). peasants became impoverished, moved to cities -​ ostrom’s system of quotas, monitoring and enforcement -governance without government  -​ cooperate, but punish defections and return to inice Private Rights and Common Rules ​ Private Rights: Individuals or businesses own property and are responsible for managing it efficiently. Example: A farmer owning land keeps it productive. ​ Common Rules: Shared resources (like public land) need rules to avoid overuse. Example: Limits on fishing quotas to protect fish stocks. Institutions: ​ Societies create institutions (laws, organizations) to enforce these rules, ensuring fairness and preventing resource misuse. Game Structure and Market Power 1. Ultimatum Game ​ How It Works: ○​ One player (the proposer) offers a share of $100 to another player (the responder). ○​ If the responder accepts, they both get paid. If they reject, neither gets anything. ​ Lesson: ○​ Monopolists (like the proposer) can offer unfair deals ("take it or leave it"). ○​ This is why governments prevent monopolies — so no one company controls the market. 2. Dictator Game ​ How It Works: ○​ The proposer decides how to split the money, and the responder must accept. ​ Lesson: ○​ This shows extreme market power, where one party has total control. ○​ Even here, fairness can matter: If the proposer is too greedy, the responder may refuse to cooperate in the future. Values and Behavior ​ Social Norms Matter: ○​ Even when accepting any money is "rational," people often reject unfair offers to punish greedy players. ○​ Smart players will anticipate rejection and offer fairer splits.  -​ cooperate, but punish defections and return to inice PARETO EFFICIENCY AND ECONOMIC OUTCOMES -​ pareto efficiency= there is no alternative where at least one person would be better off and nobody is worse off; win-win situation even if compensation is there PARETO EFFICIENCY AND COMPENSATION Pesticide Game ​ Problem: If farmers both spray pesticides (T,T), they get the lowest total output due to environmental damage. ​ Issue: Helping only one farmer (moving from T,T) isn’t efficient because one gains while the other loses. Solution: Side-Payments ​ One farmer could reduce pesticide use while the other compensates them. ​ Both farmers’ total output increases, making everyone better off. ​ Policy Fix: The government could tax pesticide use and redistribute funds, replacing direct farmer payments. Tragedy of the Commons (Overgrazing Example) ​ Problem: If both farmers overgraze, the land depletes (a Nash equilibrium). ​ Better Outcome: If both restrict grazing, they get better payoffs but need a reason to cooperate. Policy Fix: Overgrazing Tax ​ Example: Tax for cows beyond 10 reduces overgrazing profits. ​ New Nash Equilibrium: Both farmers restrict grazing since overgrazing is now costly. ​ Fairness: The tax applies equally to all, forcing farmers to consider their impact on the land. Games, Efficiency, and Norms Encouraging Organic Farming (I,I)  -​ cooperate, but punish defections and return to inice 1.​ Persuasion: ○​ Promise better productivity and sustainability. ○​ Focus on win-win outcomes. 2.​ Compensation: ○​ Pay farmers to switch, even if they’re skeptical. 3.​ Taxes: ○​ Tax harmful farming methods to encourage alternatives. Policy Challenges ​ Unintended Consequences: ○​ Taxes can change people’s preferences in unexpected ways, causing policy failure. ​ Nash Equilibrium: ○​ If farmers can’t improve their outcomes by switching strategies, they’ll stick to the policy’s intended behavior — unless fairness norms make them act differently. 1. Price Elasticity ​ Elastic Demand: People buy less if prices rise (stretchy). ○​ Example: Luxury items like gadgets or vacations. ​ Inelastic Demand: People buy the same amount, even if prices rise (fixed). ○​ Example: Necessities like food, fuel, or medicine. Policy Insight: ​ Taxes on inelastic goods raise revenue but don’t reduce consumption. 2. Price as a Social Signal ​ Example: Fining parents for late child pickup made them later. ​ Why? The fine made being late seem like a paid service, replacing the social obligation to be on time. 3. Tax Avoidance Game How It Works:  -​ cooperate, but punish defections and return to inice ​ The government chooses Moderate Taxes (A) or High Taxes (B). ​ Firms choose to Pay Taxes (C) or Hire Tax Lawyers (D) to avoid them. Example: ​ If the government raises taxes, firms may hire tax lawyers to avoid paying more. ​ This shifts the firm’s strategy, leading to less tax revenue. Tax Revenue is the money the government collects from taxes. It comes from various sources, such as: ​ Income Taxes: Paid by individuals and businesses on their earnings. ​ Sales Taxes: Charged on goods and services people buy. ​ Property Taxes: Paid on land and buildings. ​ Corporate Taxes: Paid by companies on their profits. ​ Excise Taxes: Charged on specific goods like fuel, tobacco, and alcohol. ​ Summary 1.​ Public Policy Purposes: ○​ Functional: Fix market failures (like unfair competition). ○​ Normative: Address fairness and equality. 2.​ Games, Efficiency & Norms: ○​ Balance outcomes with fairness norms. ○​ Use side-payments and taxes to encourage better behavior. 3.​ Policy Tools: ○​ Tax & Redistribute: Fund services, encourage fairness. ○​ Command & Control: Set rules (anti-monopoly laws). ○​ Inform & Persuade: Promote good behavior. 4.​ Challenges: ○​ Price Elasticity: Taxes only work if people respond to prices. ○​ Compliance: Policies must account for how firms or people may adapt to avoid rules. LECTURE 4  -​ cooperate, but punish defections and return to inice What Can Production Functions Tell Us? 1.​ Marginal Product: ○​ This shows how much more output you get when you add one more unit of input (like time or effort), while keeping other inputs the same. ○​ Example: If you study for 1 extra hour and your grades improve, that improvement is the marginal product of your extra study time. 2.​ Diminishing Marginal Product: ○​ This means the more you do something, the less effective each additional unit becomes. ○​ Example: The more coffee you drink, the less enjoyable each cup becomes. Opportunity Costs ​ Trade-offs: You have limited resources (time, money), so you have to make choices. ○​ Example: If you study more, you might get better grades but have less free time. ○​ Constraints: Things like limited time or money affect your choices. ​ Opportunity Cost: ○​ This is what you give up when you choose one action over another. It’s the benefit you miss out on from the next best alternative. ○​ Example: The time you spend studying in college could have been spent working, so your opportunity cost is the lost income plus the future benefit of having a degree. ​ Economic Cost: ○​ This is the total cost of an action, including both monetary costs (money spent) and subjective costs (like enjoyment or stress). ○​ Example: The cost of attending college includes tuition fees and the personal enjoyment (or stress) of studying. OPPORTUNITY COSTS AND COMPARATIVE ADVANTAGE (getting money) Lionel Messi: Athlete One of the greatest players of all time Also: maybe the greatest tuba player also He has an absolute advantage in both activities Good in either Should Lionel have taken time off playing soccer- ball to play tuba? No: comparative advantages differ greatly  -​ cooperate, but punish defections and return to inice tuba players (even the greatest) don’t make much money, while soccer-ball players can earn $$$$$ PREFERENCES AND OPPORTUNITY COSTS: CONCERT VS. PARK (4.3 ESPP) FROM PRODUCTION FUNCTION TO FEASIBLE SET The feasible frontier shows the maximum output that can be achieved with a given amount of input. The marginal rate of transformation (MRT) is the slope of the feasible frontier, and it represents the tradeoffs an individual faces(opportunity costs) basically how much you have to do  -​ cooperate, but punish defections and return to inice The feasible frontier can also be applied to trade-offs in economic Production with Available Resources: ​ Applied to a firm or a nation. Frontier Movement: ​ Up/Out: As the economy or firm grows and becomes more productive. ​ Shrinks: When the economy or firm weakens or loses resources. Comparing Capacity: Shows how much can be produced with available resources Technological progress: Production function Technological progress increases the amount (of grain) produced in a given number of hours. (You could also think of experience.) Notice that the new production function is steeper than the original one. The new technology has increased the marginal product of labour: At every point, an additional hour of work produces more grain. Farmer’s production function shows how labor is used to produce grain Technological Progress and Feasible Frontier ​ Feasible Frontier: Shows how much grain a farmer can produce for each amount of free time. ​ Technological Change: Expands the possible combinations of grain and free time. ​ Opportunity Cost: With technology, an hour of free time becomes more valuable because the farmer can produce more grain in less time, making the opportunity cost higher. Pareto Efficiency and Production Frontiers ​ Pareto Efficiency: A situation where no one can be made better off without making someone else worse off. ​ Production Possibility Frontier (PPF): The boundary that shows the maximum possible output combinations of two goods (like grain and free time) a farmer can produce.  -​ cooperate, but punish defections and return to inice Your preferences! In economics (and in other social sciences), we measure Preferences in Terms of Utility ​ Utility: The satisfaction or benefit you get from consuming a good. ​ Expected Utility: The potential satisfaction or benefit an actor expects to gain from choosing a certain option. Preferences and the Production Possibility Frontier (PPF) ​ The PPF shows the possible and efficient combinations of goods you can produce. ​ It doesn't tell you which combination will be chosen; that depends on the preferences of the individual. ​ Assumptions: We usually assume preferences (whether rational or not), like which good a person prefers more. Ideally, we could ask individuals directly. INDIFFERENCE CURVES AND PREFERENCES Decision of how much to study depends on preferences A is preferred to B. D is preferred to C. A is not preferred to E. E is not preferred to A. all the combinations give same utility in a,e,f,g,h,d An indifference curve joins points that cannot be ordered. ICs show all combinations that give the same utility.  -​ cooperate, but punish defections and return to inice WHAT CAN INDIFFERENCE CURVES TELL US?​ The marginal rate of substitution (MRS) is the slope of the indifference curve.- how much you are willing to do It represents the trade-offs an individual is willing to make. Properties of Indifference Curves 1.​ Downward Sloping: ○​ Indifference curves slope downward because of trade-offs. If you want more of one good, you have to give up some of the other. 2.​ Higher Curves = Higher Utility: ○​ Curves further from the origin represent more of both goods, meaning more satisfaction or utility. 3.​ Smooth Curves: ○​ Indifference curves are usually smooth, showing consistent preferences without sudden jumps. 4.​ No Crossing Curves: ○​ Indifference curves don’t cross because each point on a curve represents an equal level of satisfaction, and crossing would mean two different levels of utility. 5.​ Diminishing Marginal Rate of Substitution (MRS): ○​ As you move along the curve, the slope gets flatter. This reflects the idea that you don't want too much of one good—preferences change as you get more of one and less of the other.  -​ cooperate, but punish defections and return to inice PRODUCTION AND PREFERENCES TOGETHER: OPTIMAL CHOICE (on the exam)- the amount you are willing to put in is the same as the amount you have to put in ​ MRS (Marginal Rate of Substitution): This is how much of one good you are willing to give up in exchange for more of another good, while keeping your satisfaction level the same. ​ MRT (Marginal Rate of Transformation): This is the actual tradeoff between the two goods, meaning how much of one good you have to give up to get more of the other, based on what’s available or possible. When we say MRS = MRT, it means the amount you're willing to trade off is equal to the amount you actually have to trade off in the real world. At point E, the indifference curve (a line showing combinations of goods that give you the same satisfaction) just touches the feasible frontier (the boundary of what you can afford) but doesn’t cross it. This means you're getting the most satisfaction possible with what you can afford, and that's why it’s a point of tangency.  -​ cooperate, but punish defections and return to inice Angela the Farmer & Technological Change ​ Effect: Tech progress lets Angela produce more with less work, improving her standard of living through more free time and consumption. ​ Feasible Frontier (FF >> FF tech): Her maximum possible output shifts outward, allowing better choices. ​ Preferences (IC): She chooses the point where the new FF touches her highest indifference curve, maximizing happiness. Why Study Optimal Choice? ​ Trade-offs: Shows how limited resources are allocated: ○​ Students: Study vs. free time. ○​ Governments: Guns vs. butter, housing vs. data centers. ​ Policy Impact: Helps predict how changes in tech or policy affect production and choices. Decisions at the Margins & Sunk Costs ​ Thinking at the Margin: People compare extra benefits vs. extra costs of actions. ​ Sunk Cost Fallacy: People irrationally stick to past investments, even when it’s no longer worthwhile  -​ cooperate, but punish defections and return to inice Imagine you paid to go see a movie. 30 minutes in you realize it is terrible. Do you keep watching the movie or leave and do something more fun. You have been in a bad relationship for more than a year that shows no signs of improving? Do you maintain the relationship because you’ve invested so much time in it? SUNK COSTS AND DECISIONS -​ One of the big ideas of economics is that it is more efficient to “think at the margins” this is what we did in this lecture Let the past be the past and focus on what effect your actions have on your future utility. Don’t fall for the Sunk Cost Fallacy Consider your opportunity costs! Not just the sticker price. next class: modelling used in land owner and farmer; effect of laws that empower.. You’ll need to read most of the chapter, but there are three sections: Everything on institutions uses the same tools and leads up to section 5.7 These tools build on the feasible frontier, plus MRS=MRT we had today. For section 5.9, focus on what the concepts for measuring inequality are and what they refer to. (Not the calculations themselves) Section 5.12 (conclusion) provides a good overview of concepts to look for, if you have a look first. LECTURE 5 The big picture: institutions can enable or limit exploitation Institutions: The Rules of the Game Impact on Production, Distribution, and Power Economic Inequality Policies to Address Inequality Institutions as rules of the game Definitions Rules, norms and values that guide political, economic and/or social behaviour  -​ cooperate, but punish defections and return to inice Known by the community Can be… formal (constitution, labor laws, Schengen Agreement) informal Action that we have no rational reason to deviate from (QWERTY(Z). hint: look at your keyboard) Norms of behavior Why care about institutions? Institutions shape incentives and therefore behaviour: They can filter how we interpret costs and benefits How we weigh opportunity costs And come with transaction costs Institutions influence growth and influence the distribution of wealth within society. Institutions and Bargaining Power ​ Institutions determine who has bargaining power in the economy. ​ This power affects how much of the economic rent (extra profit from a deal) someone can secure. Transaction Costs & Institutions ​ Transaction Costs: Efforts and costs of switching behavior, like adopting new tools or methods. ​ Three Key Costs: ○​ Search (finding options) ○​ Bargain (negotiating) ○​ Implement/Enforce (making it work) ​ Institutional Impact: ○​ Old habits are hard to change. ○​ High transaction costs slow change unless institutions are failing. Production Without Interference ​ Businesses aim to maximize output and profit.  -​ cooperate, but punish defections and return to inice ​ Producing below the Production Possibility Frontier (PPF) means missing out on potential profits. Production without interference: optimal choice MRS = MRT: The buyer’s willingness to trade money for goods equals the producer’s cost of supplying them. This is the optimal trade point where both agree. Red Line Below Blue Line: ​ Red Line (Buyer’s MRS): What the buyer wants to pay. ​ Blue Line (Producer’s MRT): The minimum the producer needs to charge. ​ If the buyer’s line is below the producer’s, the buyer wants a lower price than the producer can offer. Power Over Producers: ​ If buyers have bargaining power (e.g., many suppliers, few buyers), they can push prices down. ​ Without this power, an agreement is unlikely.  -​ cooperate, but punish defections and return to inice Institutions & bargaining power Institutions as ‘Rules of the game’ shape bargaining power: determine the ability of the players to obtain a high payoff Bargaining power = extent of a person’s advantage in securing a larger share of the economic rents made possible by an interaction. Example: Ultimatum game Purchaser’s right to make take-it-or-leave-it offers (by institutional design) enhances bargaining power, albeit constrained. Bargaining power between Producer and Exploiter 4 scenarios: Institutions can give exploiters power over producers: Slavery, sharecropping (workers bound to land, paying rent in produce) Institutionalized rights for producers increase their welfare and bargaining power.. Labour laws: minimum wages, working hours, right to refuse work etc. Bargaining power influences What influences bargaining power? Coercion  -​ cooperate, but punish defections and return to inice The rules of the game (institutions) Outside options – the ability to find work elsewhere, social safety net. BATNA: BEST ALTERNATIVE TO NEGOTIATE AN AGREEMENT Sometimes dictated by institutions Optimal Choice: Angela the independent farmer Angela farms the land by herself and keeps all the grain. She sells what she wants at the market price. Her tradeoff is between grain and free time. Optimal decision-making: allocation is where MRS = MRT Production Under Absolute Power (Coercion) A powerful actor can force production without fully paying: Controller (landlord/ employer) forces producer (worker) to split the producer’s output Producer needs a certain amount to survive: Biological survival constraint  -​ cooperate, but punish defections and return to inice Maximizing exploitation The controller will demand a mix of hours and output where their share of the production is largest (yellow line). This is the Economic Rent (unearned income) The worker only keeps the amount needed to survive: (green line and everything below it).  -​ cooperate, but punish defections and return to inice MRS- WILLING TO PAY MRT-ABILITY TO PRODUCE middle part what the controller gets and below what the worker gets Property rights limit exploitation Worker can say no once slavery abolished Institutions generate labour rights She rents land from Bruno in exchange for a share of the crop. She keeps more production for herself Over and above the biological constraint The blue line represents Angela's minimum acceptable offer (her "reservation option," z). If Bruno offers less than this, she would rather keep what she has than trade. Bruno, like in the ultimatum game, tries to offer as little as possible while still making a deal.  -​ cooperate, but punish defections and return to inice Expoiters seek to maximize remaining share Economic rent: a payment or other benefit received above and beyond what the individual would have received in their next best alternative. joint surplus- sum of all economic rents of everyone involved  -​ cooperate, but punish defections and return to inice The landlord will offer where the MRT on the production frontier equals the MRS slope on the reservation curve. That is where they get biggest economic rent Why does the landlord get all the surplus? All points along E-F are pareto efficient: both still benefit Bargaining power allows exploitation below market price No alternatives for sharecroppers (no other buyers, no alternative employment) support landlord power So farmers accept deals on the lowest indifference curve (reservation). Farmers lobbying for better voting rights, labor laws, and property rights leads to improved working conditions, like legal limits on work hours. This shifts the reservation indifference curve closer to the production frontier, meaning workers are less willing to accept poor offers because they now have better legal protections and alternatives.  -​ cooperate, but punish defections and return to inice more free time (from D to F) (small blue IC2) Institutions & balance bargaining: Farmers can still negotiate better win-win deals on IC2 curve: Angela could trade more working time for more production she can keep (from F to G) Incentives! Landlord may want a bigger share (H instead of G) farmer remains firm at point G Negotiating can therefore help both sides get more production (joint surplus) Back to production with no interference What happens when you become more productive because you keep more of the surplus? The feasibility frontier expands. Often everyone gets more Conditional on bargaining power Does this translate to now?  -​ cooperate, but punish defections and return to inice Minimum wage and social security benefits issues: Uber and food delivery workers Retail workers on zero hour contracts ( Online platforms take a third of sales from companies selling through them. (Hotels, food delivery, consumer goods, apps for your phone, etc.) Companies suck it up to get sales. Or they fight it in court to secure rights to income and consumer choice What to take away from this… Production is limited by natural and technological factors (the production frontier). ​ Reservation prices are the minimum offers people accept; deals above this create Pareto improvements (where no one is worse off, and someone is better off). ​ Institutions, like laws and rules, affect these prices and who gets what. ​ Preferences (what people want) and bargaining power (how much they can negotiate) shape outcomes. ​ Laws can create fairer distributions but still may not achieve perfect fairness. Inequality arises from differences in: ​ Physical Wealth Endowments: Assets like land, housing, or stocks. ​ Human Capital: Skills gained through education, training, and experience. ​ Technological Endowments: Access to tools like steel or microprocessors. ​ Income: Money earned from work or investments. ​ Institutions: Rules and systems that influence bargaining power, either reducing or increasing inequality. Measuring Inequality: the Gini coefficient The Gini coefficient is a number between 0 (perfect equality) and 1 (extreme inequality). The more unequally resources are distributed amongst the members of the population, the larger is the Gini coefficient. Based on differences in incomes, wealth or some other measure between people. Includes information about everyone in society, not just the rich and the poor like the Rich/Poor ratio (Unit 1).  -​ cooperate, but punish defections and return to inice A Measure of Inequality: the Gini coefficient Gini = Value between 0 and 1 0 = perfectly equal 1 = extreme inequality (one person/group has all the wealth) Captures an approximation of the inequality of a country. A way to compare across countries or over time Can’t distinguish where wealth is concentrated It is usually at the top (the richest). That is the job of the Lorenz curve (next) the lorenz curve The Lorenz Curve shows how income is spread out across a country's population. It compares the percentage of total income owned by different groups of people (like the poorest 20%, the next 20%, etc.). ​ If everyone had the same income, the curve would be a straight line going up. ​ The more uneven the income distribution (the richer some people are compared to others), the more the curve bends away from that straight line.  -​ cooperate, but punish defections and return to inice It helps us see how equally or unequally income is shared, but it doesn't tell us if the country is rich or poor overall. It just shows how income is divided. Equality: Pirate ships and the British Navy Piracy was surprisingly fair and democratic: pirates on The Rover distributed their spoils relatively equally between crew members. unlike in the British Navy.  -​ cooperate, but punish defections and return to inice Inequality Policies 1: property rights & rent control Operation Barga example: In 1978, the Left Front government in Bangladesh introduced land reforms to improve the situation for farmers: ​ Farmers were allowed to keep 75% of the crop they produced. ​ Landowners could no longer evict farmers as long as they paid the new rent. As a result: ​ Farm production per unit of land increased (meaning the overall output grew). ​ The reform wasn't Pareto efficient, meaning it didn’t make everyone better off without making anyone worse off. Some landowners might have lost out, but the policy reduced income inequality because farmers gained a bigger share of the crop.  -​ cooperate, but punish defections and return to inice Inequality Policies 2: Redistributive policies Disposable income = Income available after paying taxes and receiving transfers from the government Redistributive government policies (income tax and transfers) can result in a more equal distribution of disposable income. Pre- and Post Institution Inequality: Market Gini and Disposable Gini Differences in inequality in disposable income across countries depends on the effectiveness of these policies.  -​ cooperate, but punish defections and return to inice Take aways Identifying production frontiers and indifference curves in economic bargaining and the (in)equality of outcomes. Concepts: Joint surplus, economic rents, reservation point/curve The power of institutions to shape the distribution of surplus The power of coercion to extract economic rents Property rights, democracy, labour laws as institutions that limit this power Inequality, measurement & conditions How to map it and measure it: Gini coefficient Lorenz curve Difference b/w market & disposable income Different policies to combat inequality LECTURE 6: FIRMS OUTLINE Firms as legal entities organizing the factors of production Incomplete contracts and conflicts of interest Firms and capital: Owners and Managers Firms and labour: employees, labour productivity Labour Discipline Model Principal-agent models of corporate (firm) control Varieties: company law as institutions  -​ cooperate, but punish defections and return to inice WHAT IS A FIRM? Firm = a business organization which Employs people Purchases inputs to produce market goods and services Sets prices greater than the cost of production Has legal personality: Has legal right to sign contracts and be held accountable like a person Allows it to secure outside funds, purchase inputs, organize sales FIRMS AND CAPITALISM Firms as organizations can produce more, develop new products and innovate in ways that single craftspeople and farmers can Specialization of tasks Bringing owners/investors, managers & workers together Scaling everything up FIRM-SPECIFIC ASSETS AND COMPETITIVENESS Relationships within firms are different than market transactions: They can last longer They only make sense in that particular firm When the relationship ends, value is lost to both sides. Creation of network of colleagues Acquisition of skills & knowledge necessary for the job These skills, networks, and friendships are firm-specific assets.  -​ cooperate, but punish defections and return to inice -​ opportunity cost: should i learn this? it could be useful for my job. PROFESSIONAL MANAGERS AND THE FIRM Owners can choose to direct the activities of other participants in the firm Directly (family-owned firms) or Indirectly: through hiring managers that control on their behalf Owners still receive the firm’s profits – they are residual claimants.A residual claimant is a person or group entitled to whatever is left of a company’s income or assets after all expenses, debts, and obligations have been paid. (profits from the company belong to them, not managers or workers) Managers ≠ owners Separation of Ownership and Control This happens when the people who own a company (shareholders) are not the ones running it. Instead, managers are hired to make decisions about how to use the company’s funds. This can create a potential conflict if managers’ goals differ from what the owners want. CONTRACTS Contract: A legal document (direct) or understanding that (indirect) Specifies actions that contracting parties must do, including Rights and responsibilities Contracts in the firm are not like market contracts: Based on authority of owners(CEO-chief executive owner), not free exchange Company= network of contracts ceo: set wages, decide on budget etc. Firms have multiple contracts:  -​ cooperate, but punish defections and return to inice over the factors of production (capital, labour, supplies) and the tasks of management on behalf of owners That allow them -​ there were companies that did not have oficial direct contracts, but worked as a firm. CONTRACTS AND CONFLICTS OF INTEREST Economists like contracts that are complete: Every scenario is spelled out Those with power (principals) can control what others (agents) do Principal-agent relations involve agents doing unforeseen things Incomplete contracts make this possible (not all eventualities foreseen) Principals will try to improve contracts to improve information, rectify behaviour INCOMPLETE CONTRACTS AND EMPLOYEES ​Hiring employees is different from buying other goods and services. The contract between a firm and its employees is incomplete: Some tasks depend on future (unknown) events Some aspects of the job are difficult to measure and base wages on e.g. effort Incomplete contract does not specify, in an enforceable way, every aspect of the exchange that affects the interests of parties. PRINCIPAL-AGENT MODELS Principal-agent models capture interactions under incomplete contracts Firm is the principal and the worker is the agent  -​ cooperate, but punish defections and return to inice Owners are the principals and the managers are their agents Agent drift: Agent does something unintended Action is hidden from the principal (principal lacks information that the agent has: info asymmetry) The principal cannot verify it until it has already happened OWNERS AND MANAGERS: CONFLICTS OF INTEREST The firm’s profits legally belong to the people who own the firm’s assets. Managers have a duty to serve the owners, but They may have a greater interest in unprofitable strategies -​ Long-term profitability: Investing in green initiatives can be costly upfront but may bring long-term benefits like reduced costs, better reputation, and sustainability. -​ Short-term profitability: Avoiding green investments can save money now, boosting immediate profits. This creates a conflict of interest between: ​ Managers: They might want to invest in sustainability for long-term success. ​ Owners/Shareholders: They might prefer immediate profits and higher returns on their investments -​ -​ STRUCTURE OF A FIRM  -​ cooperate, but punish defections and return to inice Owners decide on long-term strategy, often hire managers Managers implement their decisions by assigning tasks to workers and monitoring them, buying inputs, managing production & sales ASYMMETRIC INFORMATION Asymmetric information problems occur when one side in a relationship knows more than the other. In companies, this happens because: ​ Owners/Managers don’t know what subordinates know or do: Managers can't always monitor employees' actions or how much effort they put into their work. ​ Agents/Workers may drift: Employees might focus on tasks that benefit them personally (like taking longer breaks or working slowly) rather than what helps the company SOLVING MANAGER-OWNER CONFLICTS OF INTEREST To fix asymmetric information, companies use two strategies: 1.​ Incentives: Link managers’ pay to company performance (like share price) to motivate them. 2.​ Control: The Board of Directors monitors managers, demands changes, and can fire them if needed.  -​ cooperate, but punish defections and return to inice SIMPLE CONTRACTS: PIECE RATE PAY !!EXAM Piece Rate Pay ​ Workers are paid a fixed amount for each product they make. ​ More output = more pay or fewer hours worked. ​ Incentive: Encourages workers to be productive. Why It's Rare Today: ​ Hard to measure output in modern jobs. ​ Teamwork makes individual effort harder to track. ​ Most jobs pay a fixed salary (monthly, weekly, or hourly) regardless of output. WORKERS’ EFFORT Why do workers work hard if they get paid by the hour, month? Work ethic? Feelings of responsibility? To reciprocate a feeling of gratitude for good working conditions? Benefits for measurable output? Promotions? Fear of being fired? MATERIAL INCENTIVES TO DO A GOOD JOB: INCENTIVES AND WORK: EMPLOYMENT RENTS Employees work harder when they receive an employment rent. The employment rent applies to income above the minimum wage or unemployment insurance Cost of job loss  -​ cooperate, but punish defections and return to inice Employment Rent refers to the extra value a worker gets from having a job compared to being unemployed. It includes: 1.​ Lost Income: No pay while job hunting. 2.​ Transaction Costs: Expenses like relocation for a new job. 3.​ Non-Wage Benefits: Loss of perks like health insurance. 4.​ Social Costs: Stigma or shame of being unemployed. CALCULATING EMPLOYMENT RENTS Reservation Wage is the minimum wage a worker is willing to accept for a job. It depends on the value of the next best option, such as: ​ Other employment: What they could earn in a different job. ​ Unemployment benefits: Government support or financial aid received while unemployed. Employment rent =The formula wage - reservation wage - disutility of effort is used to explain the decision-making process for workers considering a job. Here’s what it means: ​ Wage: The pay offered for the job. ​ Reservation wage: The minimum wage the worker is willing to accept (based on other options, like benefits or alternative jobs). ​ Disutility of effort: The discomfort or negative feelings about the work (e.g., stress, physical effort, long hours).  -​ cooperate, but punish defections and return to inice Why pay employment rents? Besides employee motivation to work hard and well, employment rents Worker Retention: ​ Offering good wages and benefits makes workers more likely to stay at the company. ​ This helps the company save money because they don’t have to spend on hiring and training new workers. Recruitment: ​ Offering good wages and benefits attracts more job applicants. ​ This gives the company a larger pool of people to choose from when hiring. EMPLOYMENT RENTS, INCENTIVES AND DISCIPLINE The employer cannot directly measure the worker’s effort. A large employment rent means the worker values their job a lot because losing it would be costly (due to things like lost income, benefits, and job search effort). ​ Large cost of job loss makes the worker work harder to avoid getting fired.  -​ cooperate, but punish defections and return to inice ​ One way for a company to increase the cost of job loss is by offering higher wages, which makes workers more motivated to keep their job. THE EMPLOYMENT GAME 1. The employer chooses a wage. As long as the worker works hard enough, she will keep her job at the offered wage. 2. The worker chooses a level of work effort, taking into account the costs of losing her job if she does not provide enough effort. Payoffs: Firm: Profit = worker's output – wage Worker: Employment rent BEST RESPONSE CURVE The Best Response Curve shows the optimal effort a worker will put in for each wage offered by the firm. ​ It helps to understand how much effort workers are willing to exert at different wage levels. ​ It represents the firm's feasible frontier, showing the trade-off between wages and effort. ​ The slope of the best response curve is called MRT (Marginal Rate of Transformation), which shows the rate at which the firm can trade off wages for effort (how much effort increases as wages rise). FIRM’S BEST RESPONSE  -​ cooperate, but punish defections and return to inice Firms choose a wage that balances cost (wage) and work effort to maximize profits. Here's how: 1.​ Minimize Costs: Firms want to keep production costs low. Paying higher wages can motivate workers to put in more effort, but the firm must ensure this is cost-effective. 2.​ Best Response: The firm figures out the optimal wage where the cost of paying workers is balanced with the effort they provide. This is called making the best response. 3.​ Graphing: This relationship can be shown on a graph, where the firm finds the wage level that minimizes the cost per unit of effort. 4.​ Optimal Choice: By applying the worker's best response (how effort changes with wage), the firm can find the optimal wage-effort combination for maximum profit. ISOCOST LINES FOR EFFORT Cost of effort: This is the trade-off between how much the firm pays in wages and how much effort it gets from workers. At all points on the isocost line, the cost of effort remains the same. Slope of the isocost line (MRS): The slope represents the marginal rate of substitution (MRS), which shows how much the firm is willing to increase wages to get more effort from workers. Steeper line: The steeper the isocost line, the more effort the firm gets for each additional wage it pays. This means the firm can achieve higher worker effort with a smaller increase in wages. High vs low cost of effort: The isocost line will be steeper when the cost of effort is low because the firm can get more effort with less increase in wages. If the cost of effort is high, the line will be flatter, meaning the firm has to pay more to get the same amount of effort. between the wages a firm pays and the level of effort workers are willing to put in.  -​ cooperate, but punish defections and return to inice SETTING WAGES Firms choose the steepest isocost line to maximize profits, subject to the worker’s best response curve. All wages higher than the reservation (minimum) wage are called efficiency wages: incentives to put in effort MRS=MRT  -​ cooperate, but punish defections and return to inice minimum feasible cost= not in exam UNEMPLOYMENT, INSURANCE AND THE RESPONSE CURVE The best response function will shift in reaction to changes in: Reservation wage (minimum wage, unemployment insurance) Level of unemployment (likelihood of losing job, finding new work) Cost of living Is this in NYC or Vilnius?  -​ cooperate, but punish defections and return to inice Company Law defines the rights and responsibilities of owners, managers, and workers, influencing power dynamics within a company. Here's how it works: 1.​ Varieties of Capitalism: Different countries approach company law in ways that affect the balance of power between stakeholders: ○​ UK & US: Company law strongly supports owners’ rights to profits. Employees, suppliers, and other stakeholders' interests can be overlooked. Managers are responsible for maximizing profits, and if they fail, they can be held accountable. ○​ Germany: Company law emphasizes shared responsibilities between owners and managers to employees. Employees have guaranteed roles in management and are involved in decision-making through works councils (groups representing workers on the shop floor). Employee retention is supported through job protection and giving workers a say in company matters. This highlights how company law can shape the relationship between employers and workers, influencing everything from profit priorities to employee treatment. DO VARIETIES MATTER? Owner-oriented companies have advantages in: Raising capital: owners know they can control the company. They can attract additional shareholders, who also own a share of the company.  -​ cooperate, but punish defections and return to inice Flexibility: owners can shut down parts of the company as they like (hire/fire employment, using money to hire new talent & suppliers) Innovation are businesses that consider the interests of a broader range of groups, not just the owners or shareholders. stakeholder-oriented companies have these advantages: 1.​ Patient Capital: These companies tend to have long-term relationships with investors, banks, and other stakeholders, which allows them to have stable and patient capital. 2.​ Planning: A stronger relationship with stakeholders means these companies can focus on longer-term planning rather than short-term profits. 3.​ Building on Existing Products: Stakeholder-oriented firms can use their existing assets, knowledge, and relationships to improve or expand their products, building on what they already have. OTHER TYPES OF BUSINESS ORGANIZATIONS 1. Cooperative firm = workers own firm, can hire and fire managers. Requires fewer supervisors to monitor employees Has smaller inequalities in wages and salaries. 2.The gig economy refers to a system where a digital platform (like an app or website) connects freelancers or independent workers (those offering services) with customers (those paying for the services). Piece work and complete contracts are possible due to well-defined tasks OUTLINE Firms as legal entities organizing the factors of production Incomplete contracts and conflicts of interest Firms and capital: Owners and Managers Firms and labour: employees, labour productivity Employment rents, isocost & best response curves,  -​ cooperate, but punish defections and return to inice Profit maximization at MRS=MRT Principal-agent models of corporate (firm) control Varieties: company law as institutions office hours MRT IS ALWAYS AB PRODUCTION, TRANSFORMATION IN THE RAIN GUNS VS BUTTERS; MAKING SOMETHING ABOUT WHAT YOU HAVE MRS (substitution); i can choose this or that, always about purchasing/paying and all about that feasible frontier applies to one product (ex: bushels of grain) really not different; indifference curves: low indifference curve= low expectations high indifference curve= higher expectations LECTURE 7: PRODUCTION SUPPLY AND DEMAND Today Economies of Scale Demand Curves: Elasticity of demand and prices Supply Curves Equilibrium prices Monopoly rents (non-competitive prices)  -​ cooperate, but punish defections and return to inice Economic shocks and inflation effects ECONOMIES OF SCALE DRIVE FIRM PRODUCTION STRATEGY Economies of Scale: The more units produced, the lower the average cost per unit The curve slopes downward >> Diseconomies of scale: Average cost per unit increases with the number of units produced Need more equipment & workers Increasing cost of other inputs  -​ cooperate, but punish defections and return to inice ECONOMIES OF SCALE: WHY? Fixed costs are costs that stay the same no matter how much you produce or how many customers you have, like research, office space, software, or legal fees. ​ Benefits of fixed costs: As production increases, fixed costs are spread over more units, making the cost per unit cheaper. Advantages of large size: 1.​ Bargaining power: Larger companies can buy inputs at lower costs. 2.​ Division of labor: A bigger workforce allows for specialization, increasing expertise. 3.​ Competitive pricing: Large companies can sell more at lower prices, making it harder for competitors. 4.​ Demand advantages (network effects): The value of a product increases as more people use it. For example, software becomes more valuable when many people use it because of interoperability—users can easily interact with each other. DEMAND CURVES Demand curve shows the quantity demanded at different prices by buyers. Willingness to pay (WTP) determines quantity demanded: how much buyers are willing (and able) to purchase at a particular price At a high price, few people will pay (or can)  -​ cooperate, but punish defections and return to inice We can read this two ways: Horizontally: The quantity buyers are willing and able to purchase at a given price. Some buyers will pay more even at high prices Vertically: The maximum price that buyers are willing to pay for a given unit of CTC produced. Many buyers will buy more units, at lower prices  -​ cooperate, but punish defections and return to inice WHO GAINS? THE CONSUMER SURPLUS: Consumer gain from the transaction Difference between market price (low) and price a consumer is willing to pay for a given quantity Total consumer surplus is the surplus of all buyers and all units of the good. You could calculate with the area of the triangle: ½(base * height) In this example: ½(50*(60-15)) = 1,125  -​ cooperate, but punish defections and return to inice DIFFERENCES IN DEMAND: INCOME EFFECTS Normal Goods Demand goes up as income goes up Most goods (hence “normal”) Inferior Goods Demand goes up as income goes down Example: Instant Ramen Noodles ELASTICITY  -​ cooperate, but punish defections and return to inice Elasticity = −% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑑𝑒𝑚𝑎𝑛𝑑/ % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 (not in exam) When demand rises or falls with price, demand is elastic Not all demand for goods or services is: Where is the technical dividing line between inelastic and elastic? Demand is elastic if the % change in demand is stronger than % change in price ELASTIC GOODS Elastic goods: people buy less as prices rise Goods that have competitive substitutes (competition boosts elasticity) A-Brands vs. B-Brands within stores (Groceries from Lidl instead of Albert Heijn, or AH House Brands) Luxury items: Desirable, but not essential Goods that are dispensable: nice to have, not have to have Consumption can be put off: staycation instead of a vacation away INELASTIC GOODS People keep buying, even when prices rise Goods that have few competitive substitutes Harder to adjust by buying other things as prices go up Coffee drinkers can’t simply shift to tea and vice versa  -​ cooperate, but punish defections and return to inice Essentials vs. non-essentials (clothes for growing children vs. adult wardrobe) Time horizons / transaction costs Time & effort it takes to find substitutes to avoid higher prices If oil prices stay high, you might buy an electric car or move closer to work/train station. In the short term, you’re not going to sell your auto or house Elasticity: why care? Firms can exploit inelasticity to charge higher prices Few alternatives Inflation increases more easily when product prices are inelastic We have to keep buying, so we find a way to pay Market Power and price elasticity  -​ cooperate, but punish defections and return to inice Market power: a company’s product has few or no close substitutes Since competition supports elasticity of demand, Offering more product at lower prices, But demand becomes relatively inelastic without substitutes. Company can set prices without losing customers to competitors -​ when you have 5 companies or fewer, you can make market agreements more easily, oil companies, banks, internet service providers, not very well regulated. THE SUPPLY CURVE Setting prices & production: Marginal Revenue (MR): The extra money a company earns by selling one more unit of a product. Marginal Cost (MC): The extra expense a company pays to produce one more unit of a product. Key Insight: ​ If MR > MC: The company should produce more because it makes a profit on each additional unit. ​ If MR < MC: The company should produce less because it loses money on each extra unit. ​ If MR = MC: The company is at its profit-maximizing level, producing the ideal amount for maximum profit. Marginal Revenue & Cost We could set different prices for everyone (perfect pricing) But that’s hard to do (information, effort, cost), unless you track shopping history Albert Heijn has high prices, but offers you deals based on your shopping history (if you allow them to register you purchases with your AH Card) Firms often choose an aggregate where: Marginal revenue (MR)  -​ cooperate, but punish defections and return to inice MR: how much money do we earn if we sell a certain quantity? equals Marginal cost (MC) How much money do we spend to generate revenue? At a set price, each unit sold brings the same income (MR) But diseconomies of scale cause costs to rise over time: the MC cost starts to rise. If MR > MC (red line is above the blue line), you can earn more by producing more. If MC > MR (blue line above the red), higher costs of production are losing you money with each additional unit. You stop. SUPPLY CURVE Shows how much sellers are willing to supply at different prices, given MR& MC  -​ cooperate, but punish defections and return to inice There is a supply curve for every different good At a low price, there are few incentives to supply products in high quantity How to read this: Horizontally: How much suppliers are willing and able to sell at each price level Vertically: The minimum price at which suppliers will sell at each quantity.  -​ cooperate, but punish defections and return to inice Producer Surplus: The difference between market prices ($45) and minimum price at which producers would be willing to sell at a given quantity ($15) What the producers gain from a transaction. Total producer surplus is the sum of producer surplus for all units Supply Curve shifts: When supply increases, supply curve shifts to the right (and/or down) Supply more at same or lower price Producers are willing to earn their money selling more product, even at a lower price per unit Because at a greater supply, producers are willing to take a lower price. (or greater quantity supplied at same price) What leads to an increase in supply? Reduction in costs: technology  -​ cooperate, but punish defections and return to inice input prices taxes & subsidies Under competitive markets : the market price is where supply and demand meet: equilibrium price & quantity Why? Market actors adjust! If a company tries to sell more product at a higher price (beyond the demand curve), they won’t sell. Other firms will offer at a lower price The first company will also adjust prices downward  -​ cooperate, but punish defections and return to inice GAINS FROM TRADE  -​ cooperate, but punish defections and return to inice the supply curve: the company does not want to supply beyond the line supply demand and equilibrium From the intersection of the curves we can read price and quantity Where market competition is high How are prices set and profits made when markets aren’t competitive? Monopoly: A firm that is the only seller of a product without close substitutes.  -​ cooperate, but punish defections and return to inice Oligopolies: A small number of firms producing the same product Cartels: a group of companies that keeps prices artificially high, production low These firms can set prices above the market rate without competition. They set prices to maximize profit rather than production. ​ Monopoly rents are unearned income that a monopoly earns by charging higher prices than in a competitive market. ​ Since the monopoly is the only seller, it can set prices above production costs, creating extra profits without increasing efficiency. Deadweight Loss ​ Deadweight loss happens when some potential economic benefits are lost due to the monopoly's pricing. ​ The monopoly charges higher prices, so some consumers who would have bought the product at a lower price can’t afford it. ​ Neither the monopoly earns that lost revenue nor do consumers get the product, resulting in a waste of economic potential. PROFIT MAXIMISATION AND MONOPOLY PRICES Demand curve = Firm’s feasible frontier (slope = MRT) Isoprofit curves = Firm’s indifference curves (An indifference curve shows different combinations of two goods that give a person the same level of satisfaction or happiness.) (slope = MRS) Horizontal line: market price Lower blue curve: price with competition Upper blue curve: company shifts to higher price, lower quantity in the demand curve (price it can get away with at current demand) Firm maximizes profits by choosing point where MRS = MRT  -​ cooperate, but punish defections and return to inice Deadweight loss (DWL) = gains of trade lost compared to competitive markets Company is no longer producing as much (point E) Better off selling only to richer customers. Deadweight Loss in economics happens when resources are not used efficiently, causing a loss of value or benefit to society. It occurs when: ​ Prices are too high (fewer people buy the product). ​ Prices are too low (producers can't cover costs). ​ Taxes or regulations distort the market. Total surplus is highest when Demand = Marginal Cost  -​ cooperate, but punish defections and return to inice (point F) Monopoly Markup Explained ​ Monopoly Rents: Profits a monopoly makes by being the only supplier. ​ Highest Profits: When demand is inelastic (people still buy even if prices rise). ​ Why? People have no alternatives, so the company can charge more. ​ Result: Higher prices, restricted supply, and deadweight loss (society loses because fewer people can afford the product). preferences for the company to be lazy but also to make profit allows it to make to changes in supply, typical situation for cartels and monopolies  -​ cooperate, but punish defections and return to inice Market Power and Public Policy: Competition Policy (Government Regulation):​ Goal: Combat excessive market power and deadweight loss.​ How: 1.​ Limit Company Size: Break up large companies (e.g., Google’s search vs. analytics business). 2.​ Restrict Exploitative Practices: Prevent unfair deals between companies. 3.​ Prevent Market Entry Barriers: Stop dominant companies from buying or suing startups, or using aggressive pricing to block competition. Why? ​ To protect consumers from high prices and low production. ​ To help new and smaller businesses compete fairly. Economic Shocks and Inflation: Why Are Prices Rising (Inflation)?​ Sources: 1.​ Rising Input Costs: Energy, raw materials, and wages become more expensive. 2.​ Demand Shifts: Sudden changes in what people want to buy. 3.​ Restricted Production: Supply chain issues or reduced production capacity. 4.​ Greedflation: Companies raising prices unfairly for extra profit. Examples of Recent Economic Shocks: ​ COVID-19 Pandemic: Reduced labor supply and increased demand for manufactured goods. ​ Russia-Ukraine War: Lower supply of essential goods like energy and food, driving prices up. Why It Matters: ​ Inflation makes it harder for governments to manage the economy. ​ Consumers struggle with rising costs, and markets take longer to adjust.  -​ cooperate, but punish defections and return to inice ECONOMIC SHOCKS: DEMAND-LED EFFECTS -increased demands leads to increase supply but also increased prices -book example: applies to manufactured goods during covid ECONOMIC SHOCKS: SUPPLY-LED EFFECTS -​ decreased production -​ from Q to Q’ -​ leads to increased prices -​ oil cartel example from book but also: russia invasion of ukraine  -​ cooperate, but punish defections and return to inice Decreased production (supply) From Q to Q’ (S to S’) leads to increased prices Oil cartel example from book: but also: Russia invasion of Ukraine, 2022- 2023: War reduces energy & food supplies, prices rise OPEC cooperates to keep fuel scarce Summing up: Key Economic Concepts Simplified: 1.​ Supply and Demand Curves: ○​ Supply Curve: Shows how much producers are willing to make at different prices. ○​ Demand Curve: Shows how much consumers are willing to pay at different prices. 2.​ Perfect Competition: ○​ Definition: A market where many businesses sell similar products. ○​ Outcome: Prices are competitive, and profits are low because products can be easily substituted.  -​ cooperate, but punish defections and return to inice 3.​ Monopoly Power: ○​ What Happens: A single company can raise prices and reduce production. ○​ Effects: ​ Deadweight Loss: Society suffers because fewer goods are produced and sold. ​ Less Innovation: Competitors struggle to enter the market. 4.​ Competition Policy (Government Regulation): ○​ Purpose: To prevent monopolies and protect consumers. ○​ Methods: ​ Break up large companies. ​ Set rules against unfair practices. 5.​ Economic Shocks and Inflation: ○​ Economic Shocks: Sudden changes that affect supply or demand (e.g., wars, pandemics). ○​ Inflation: When prices rise due to increased costs, high demand, or limited supply. LECTURE 8: LABOUR MARKETS ECONOMICS THE LABOUR MARKET We often need to work for a living, so employment matters Unemployment matters, as well as the kind of unemployment it is How easy is it to find new work? What do we have to do? As governments: employment keeps the economy going (and taxes flowing) They identify different parts of the labour market, figure out whether there is something to do, and what it is. But work within domestic politics The structure of the labour market differs widely across countries.  -​ cooperate, but punish defections and return to inice Key labour market statistics Countries with the same unemployment rate can have different prospects of recovery if their employment rates if: participation rate and employment rate is high. Today: OECD & EU Labour Force Statistics: Visualizations and tables of how labour market performance varies How it varies across age groups and genders participation rate= labour force/population of working age unemployment rate= unemployed/labour force employment rate= employed/population of working age PARTICIPATION RATES What percentage of working-age people work or are looking for work?  -​ cooperate, but punish defections and return to inice UNEMPLOYMENT RATES What percentage of working-age people are looking for work but not yet employed? EMPLOYMENT RATE: YOUTH percentage of working-age people in employment GROWTH AND UNEMPLOYMENT  -​ cooperate, but punish defections and return to inice why does growth recover quickly but unemployment drop slowly? different types of unemployment Types of Unemployment (Simplified): 1.​ Structural Unemployment: ○​ Meaning: Happens when workers' skills no longer match available jobs due to long-term changes in the economy. ○​ Cause: New technologies, industry shifts, or outdated skills. ○​ Fix: Retraining workers or changing economic policies. 2.​ Cyclical Unemployment: ○​ Meaning: Caused by ups and downs in the economy (business cycle). ○​ Cause: When demand for goods and services drops, companies hire fewer workers. ○​ Fix: Government policies like unemployment benefits and economic stimulus. 3.​ Frictional Unemployment: ○​ Meaning: Happens when people are between jobs or searching for new ones. ○​ Cause: Job searches take time due to mismatches in preferences, wages, or job location. ○​ Fix: Job fairs, temp agencies, career apps, and training programs. Key Insight:​ Structural unemployment is long-term and hardest to fix, while cyclical unemployment depends on the economy’s health, and frictional unemployment is normal and temporary.  -​ cooperate, but punish defections and return to inice Political Business Cycle fiscal Stimulus (Simplified): ​ Meaning: Government actions to boost the economy, often by increasing spending or cutting taxes. ​ How It Works: ○​ Lower Interest Rates (Monetary Policy): Makes borrowing cheaper, encouraging businesses to invest and hire more workers. ○​ Short-Term Effect: Unemployment drops as businesses expand. ○​ Long-Term Effect: After elections or when the economy stabilizes, policies may reverse, and unemployment could rise again. Shocks and Long-Run Economic Changes (Simplified): 1.​ Trade and Manufacturing Relocation: ○​ Example: China Shock — China’s low-wage exports caused factory closures elsewhere. ○​ Impact: Many workers lost jobs and struggled to learn new skills. 2.​ Technological Changes:  -​ cooperate, but punish defections and return to inice ○​ Some jobs become obsolete due to tech advancements. ○​ Examples: ​ Travel Agents replaced by online booking. ​ Store Clerks replaced by self-checkout systems. ○​ Future Threat: Automation and robots may replace even more jobs. The natural rate of unemployment is the level of unemployment that exists when the economy is healthy and not in a recession or boom. It's made up of two types of unemployment: 1.​ Frictional unemployment: This happens when people are between jobs or are looking for their first job. It's a normal part of a healthy economy because workers are always moving between jobs. 2.​ Structural unemployment: This occurs when there’s a mismatch between the skills workers have and the jobs available, often due to changes in the economy (like new technology or shifts in industries). The natural rate of unemployment is the unemployment rate we expect to see when the economy is doing well and there is no cyclical unemployment (unemployment caused by recessions). It serves as a baseline for measuring the success of policies that aim to reduce cyclical unemployment, such as through monetary policy (changing interest rates) or fiscal policy (government spending and taxes). Involuntary unemployment happens when people can't find a job even though they want to work. It's c