Economics I Lectures Fall 2024 PDF

Economics I Week 2 Egon Tripodi Hertie School Egon Tripodi (Hertie) C7 Fall 2024 1 / 29  Recap & Roadmap Recap & Roadmap Egon Tripodi (Hertie)...

Economics I Week 2 Egon Tripodi Hertie School Egon Tripodi (Hertie) C7 Fall 2024 1 / 29  Recap & Roadmap Recap & Roadmap Egon Tripodi (Hertie) C7 Fall 2024 2 / 29  Recap & Roadmap Recap The wealth of nations Evolution of GDP per capita & inequality over time Measurement GDP per capita, disposable income Real and nominal GDP Three equivalent ways of measuring GDP Comparing GDP over time (real GDP) and between countries (PPP) Other measures of income and well-being Technology and the capitalist economy Defining technology/innovation in economics Climate change and capitalism Defining capitalism: private property, markets, firms Capitalism and productivity Specialization: learning by doing, difference in ability, economies of scale, task juggling Comparative advantage and gains from trade How economists learn from data Correlation vs. causation Various economic approaches to analyze data: descriptive, natural experiments, quasi-experiments, experiments Egon Tripodi (Hertie) C7 Fall 2024 3 / 29  Recap & Roadmap Today’s outline 1 Demand 2 Supply 3 Markets and equilibrium 4 Elasticities of demand and supply Egon Tripodi (Hertie) C7 Fall 2024 4 / 29  Demand Demand Egon Tripodi (Hertie) C7 Fall 2024 5 / 29  Demand Individual demand Egon Tripodi (Hertie) C7 Fall 2024 6 / 29  Demand Individual demand Egon Tripodi (Hertie) C7 Fall 2024 6 / 29  Demand Law of demand (and exceptions) Law of demand The tendency for quantity demanded to be higher when the price is lower. Egon Tripodi (Hertie) C7 Fall 2024 7 / 29  Demand Law of demand (and exceptions) Law of demand The tendency for quantity demanded to be higher when the price is lower. Can you think of cases where this could be violated? Egon Tripodi (Hertie) C7 Fall 2024 7 / 29  Demand Law of demand (and exceptions) Law of demand The tendency for quantity demanded to be higher when the price is lower. Can you think of cases where this could be violated? Giffen goods: Essential goods with upward sloping demand because, with higher prices, one cannot afford better alternatives (very rare). Example: Rice was found to be a Giffen good in Hunan province, China, in 2000s (link) (Jensen and Miller 2008) Egon Tripodi (Hertie) C7 Fall 2024 7 / 29  Demand Law of demand (and exceptions) Law of demand The tendency for quantity demanded to be higher when the price is lower. Can you think of cases where this could be violated? Giffen goods: Essential goods with upward sloping demand because, with higher prices, one cannot afford better alternatives (very rare). Example: Rice was found to be a Giffen good in Hunan province, China, in 2000s (link) (Jensen and Miller 2008) Veblen goods: Goods with upward sloping demand due to increased perceived exclusivity at higher prices. Egon Tripodi (Hertie) C7 Fall 2024 7 / 29  Demand Law of demand (and exceptions) Law of demand The tendency for quantity demanded to be higher when the price is lower. Can you think of cases where this could be violated? Giffen goods: Essential goods with upward sloping demand because, with higher prices, one cannot afford better alternatives (very rare). Example: Rice was found to be a Giffen good in Hunan province, China, in 2000s (link) (Jensen and Miller 2008) Veblen goods: Goods with upward sloping demand due to increased perceived exclusivity at higher prices. No good is always Giffen or Veblen, it de- pends on the context! Egon Tripodi (Hertie) C7 Fall 2024 7 / 29  Demand From individual to market demand Egon Tripodi (Hertie) C7 Fall 2024 8 / 29  Demand From individual to market demand Egon Tripodi (Hertie) C7 Fall 2024 8 / 29  Demand From individual to market demand Price change =⇒ movement along the demand curve Egon Tripodi (Hertie) C7 Fall 2024 8 / 29  Demand From individual to market demand Price change =⇒ movement along the demand curve The population gets richer/poorer =⇒ shifts in the entire demand curve Egon Tripodi (Hertie) C7 Fall 2024 8 / 29  Supply Supply Egon Tripodi (Hertie) C7 Fall 2024 9 / 29  Supply Individual supply Individual supply can be thought of as a production plan Example: British Petroleum decides how much gas to supply given specific prices Egon Tripodi (Hertie) C7 Fall 2024 10 / 29  Supply Individual supply Individual supply can be thought of as a production plan Example: British Petroleum decides how much gas to supply given specific prices Egon Tripodi (Hertie) C7 Fall 2024 10 / 29  Supply Individual supply Individual supply can be thought of as a production plan Example: British Petroleum decides how much gas to supply given specific prices Supply is normally upward sloping (many exceptions) Egon Tripodi (Hertie) C7 Fall 2024 10 / 29  Supply Determination of prices How are the prices determined? Egon Tripodi (Hertie) C7 Fall 2024 11 / 29  Supply Determination of prices How are the prices determined? Price-taking: sellers and buyers accept the market price as given Egon Tripodi (Hertie) C7 Fall 2024 11 / 29  Supply Determination of prices How are the prices determined? Price-taking: sellers and buyers accept the market price as given This is because the market considered here is perfectly competitive Egon Tripodi (Hertie) C7 Fall 2024 11 / 29  Supply Determination of prices How are the prices determined? Price-taking: sellers and buyers accept the market price as given This is because the market considered here is perfectly competitive Perfect Competition Markets in which: 1 All firms in an industry sell an identical good (product homogeneity) 2 There are many buyers and sellers, each of whom is small relative to the size of the market (atomistic agents) Examples: Oil refinery market, crop farming Egon Tripodi (Hertie) C7 Fall 2024 11 / 29  Supply Determination of prices How are the prices determined? Price-taking: sellers and buyers accept the market price as given This is because the market considered here is perfectly competitive Perfect Competition Markets in which: 1 All firms in an industry sell an identical good (product homogeneity) 2 There are many buyers and sellers, each of whom is small relative to the size of the market (atomistic agents) Examples: Oil refinery market, crop farming If products are not identical: leads to brand loyalty and differentiated pricing (e.g., blue jeans). Egon Tripodi (Hertie) C7 Fall 2024 11 / 29  Supply Determination of prices How are the prices determined? Price-taking: sellers and buyers accept the market price as given This is because the market considered here is perfectly competitive Perfect Competition Markets in which: 1 All firms in an industry sell an identical good (product homogeneity) 2 There are many buyers and sellers, each of whom is small relative to the size of the market (atomistic agents) Examples: Oil refinery market, crop farming If products are not identical: leads to brand loyalty and differentiated pricing (e.g., blue jeans). If agents are not small: dominant players can influence prices and market conditions (e.g., major airlines). Egon Tripodi (Hertie) C7 Fall 2024 11 / 29  Supply From individual to market supply Egon Tripodi (Hertie) C7 Fall 2024 12 / 29  Supply From individual to market supply Egon Tripodi (Hertie) C7 Fall 2024 12 / 29  Supply From individual to market supply Egon Tripodi (Hertie) C7 Fall 2024 12 / 29  Supply From individual to market supply Price change =⇒ movement along the supply curve Egon Tripodi (Hertie) C7 Fall 2024 12 / 29  Supply From individual to market supply Price change =⇒ movement along the supply curve The technology/trade shocks =⇒ shifts in the entire supply curve Egon Tripodi (Hertie) C7 Fall 2024 12 / 29  Markets Markets Egon Tripodi (Hertie) C7 Fall 2024 13 / 29  Markets Defining markets Market A setting bringing together potential buyers and sellers (i.e. where supply meets demand). Egon Tripodi (Hertie) C7 Fall 2024 14 / 29  Markets Defining markets Market A setting bringing together potential buyers and sellers (i.e. where supply meets demand). In this class, we’ll focus on markets where supply and demand are cleared by prices Egon Tripodi (Hertie) C7 Fall 2024 14 / 29  Markets Defining markets Market A setting bringing together potential buyers and sellers (i.e. where supply meets demand). In this class, we’ll focus on markets where supply and demand are cleared by prices There are markets without prices: market for organs, marriage, attention, etc. Prices are not an essential component of a market, but they serve as a useful mechanism Egon Tripodi (Hertie) C7 Fall 2024 14 / 29  Markets Market equilibrium Market is in equilibrium where demand and supply intersect This intersection reveals equilibrium prices and quantities Egon Tripodi (Hertie) C7 Fall 2024 15 / 29  Markets Market equilibrium Market is in equilibrium where demand and supply intersect This intersection reveals equilibrium prices and quantities Example: excess supply (when prices are too high) Egon Tripodi (Hertie) C7 Fall 2024 15 / 29  Markets Market equilibrium Market is in equilibrium where demand and supply intersect This intersection reveals equilibrium prices and quantities Example: excess demand (when prices are too low) Egon Tripodi (Hertie) C7 Fall 2024 15 / 29  Markets Market equilibrium Market is in equilibrium where demand and supply intersect This intersection reveals equilibrium prices and quantities Example: equilibrium Egon Tripodi (Hertie) C7 Fall 2024 15 / 29  Markets Reaching the equilibrium In reality, prices and quantities do not adjust as fast as on a graph, leading to imbalances in supply and demand Prices might not be free to adjust (e.g. due to price control, menu costs) In markets without prices, demand and supply are more likely to be imbalanced (e.g. organ shortages) Egon Tripodi (Hertie) C7 Fall 2024 16 / 29  Markets Reaching the equilibrium In reality, prices and quantities do not adjust as fast as on a graph, leading to imbalances in supply and demand Prices might not be free to adjust (e.g. due to price control, menu costs) In markets without prices, demand and supply are more likely to be imbalanced (e.g. organ shortages) Symptoms of market disequilibrium when the prices are too low: Queuing (of buyers): the extra time spent in the queue raises the effective price Bundling of extras: sellers bundle primary goods with additional goods or ser- vices to raise the effective price Example: Requiring the purchase of a VIP package to get concert tickets. Secondary markets: effective price will be higher in these markets Example: Illegal organ markets when legal supply is insufficient. Egon Tripodi (Hertie) C7 Fall 2024 16 / 29  Elasticities Elasticities Egon Tripodi (Hertie) C7 Fall 2024 17 / 29  Elasticities Price elasticity of demand: relevance Companies spend a lot of resources trying to find out what’s the price elasticity of demand. Consumer surveys Example: Netflix may send surveys to a segment of its user base to gauge how a price increase would impact subscriptions Pricing experiments Example: Through dynamic pricing, Uber assesses how riders respond to different price points in real-time Essential for predicting how a price change at scale will affect their revenues Egon Tripodi (Hertie) C7 Fall 2024 18 / 29  Elasticities Price elasticity of demand: definition Price elasticity of demand A measure of how responsive buyers are to price changes. It measures the percent change in quantity demanded that follows from a percent price change. % Change in quantity demanded Price elasticity of demand = % Change in price Egon Tripodi (Hertie) C7 Fall 2024 19 / 29  Elasticities Price elasticity of demand: definition Price elasticity of demand A measure of how responsive buyers are to price changes. It measures the percent change in quantity demanded that follows from a percent price change. % Change in quantity demanded Price elasticity of demand = % Change in price Buyers are responsive =⇒ demand is elastic (|εd | g 1) Buyers are unresponsive =⇒ demand is inelastic (|εd | < 1) Egon Tripodi (Hertie) C7 Fall 2024 19 / 29  Elasticities Price elasticity of demand: an example Egon Tripodi (Hertie) C7 Fall 2024 20 / 29  Elasticities Price elasticity of demand: an example % change in price for both cases: $2−$3 ($3+$2)/2 × 100% = −40% Egon Tripodi (Hertie) C7 Fall 2024 20 / 29  Elasticities Price elasticity of demand: an example % change in price for both cases: $2−$3 ($3+$2)/2 × 100% = −40% % change in quantity demanded: Case A: 3.15−3 (3.15+3)/2 ×100% = 4.88% Case B: 6−3 (6+3)/2 × 100% = 66.67% Egon Tripodi (Hertie) C7 Fall 2024 20 / 29  Elasticities Price elasticity of demand: an example % change in price for both cases: $2−$3 ($3+$2)/2 × 100% = −40% % change in quantity demanded: Case A: 3.15−3 (3.15+3)/2 ×100% = 4.88% Case B: 6−3 (6+3)/2 × 100% = 66.67% Price elasticity of demand: Case A: 4.88% −40% = −0.12 Case B: 66.67% −40% = −1.67 Egon Tripodi (Hertie) C7 Fall 2024 20 / 29  Elasticities Elasticity ̸= slope Slope of the demand curve is Change in price Change in quantity demanded Price elasticity of demand is % Change in quantity demanded % Change in price Slope is constant on a linear demand, but elasticity is not. Elasticity tends to be higher in the high price segment of demand Elasticity constant only in extreme cases, e.g. where demand curves are com- pletely horizontal or vertical i.e. where demand is perfectly elastic or inelastic Egon Tripodi (Hertie) C7 Fall 2024 21 / 29  Elasticities Price elasticity of demand: determinants The unifying theme is availability of substitutes. Egon Tripodi (Hertie) C7 Fall 2024 22 / 29  Elasticities Price elasticity of demand: determinants The unifying theme is availability of substitutes. 1 More competing products =⇒ more elastic demand Example: demand for Coke is elastic due to substitutes like Pepsi. Egon Tripodi (Hertie) C7 Fall 2024 22 / 29  Elasticities Price elasticity of demand: determinants The unifying theme is availability of substitutes. 1 More competing products =⇒ more elastic demand Example: demand for Coke is elastic due to substitutes like Pepsi. 2 Necessities =⇒ less elastic demand Example: demand for masks during the COVID era was relatively inelastic Egon Tripodi (Hertie) C7 Fall 2024 22 / 29  Elasticities Price elasticity of demand: determinants The unifying theme is availability of substitutes. 1 More competing products =⇒ more elastic demand Example: demand for Coke is elastic due to substitutes like Pepsi. 2 Necessities =⇒ less elastic demand Example: demand for masks during the COVID era was relatively inelastic 3 Easier consumer search =⇒ more elastic demand Example: products on online platforms have more elastic demand due to easy search Egon Tripodi (Hertie) C7 Fall 2024 22 / 29  Elasticities Price elasticity of demand: impact on revenue Price elasticity of demand is crucial for business strategy because it shapes total revenue Revenue = Price × Quantity Egon Tripodi (Hertie) C7 Fall 2024 23 / 29  Elasticities Price elasticity of demand: impact on revenue Price elasticity of demand is crucial for business strategy because it shapes total revenue Revenue = Price × Quantity Suppose the seller increases the price: If demand is elastic, the quantity de- manded will decline a lot =⇒ lower revenue Egon Tripodi (Hertie) C7 Fall 2024 23 / 29  Elasticities Price elasticity of demand: impact on revenue Price elasticity of demand is crucial for business strategy because it shapes total revenue Revenue = Price × Quantity Suppose the seller increases the price: If demand is elastic, the quantity de- manded will decline a lot =⇒ lower revenue If demand is inelastic, the quantity de- manded will decline by a little =⇒ higher revenue Egon Tripodi (Hertie) C7 Fall 2024 23 / 29  Elasticities Price elasticity of demand: impact on revenue Price elasticity of demand is crucial for business strategy because it shapes total revenue Revenue = Price × Quantity Suppose the seller increases the price: If demand is elastic, the quantity de- manded will decline a lot =⇒ lower revenue If demand is inelastic, the quantity de- manded will decline by a little =⇒ higher revenue Note: We are implicitly relaxing the perfect competition assumption here. The seller is not a price taker. Egon Tripodi (Hertie) C7 Fall 2024 23 / 29  Elasticities Cross-price elasticity of demand Cross-price elasticity of demand A measure of how responsive the demand of one good is to price changes of another good. It measures the percent change in quantity demanded that follows from a percent change in the price of another good. % Change in quantity demanded Cross-price elasticity of demand = % Change in price of another good Egon Tripodi (Hertie) C7 Fall 2024 24 / 29  Elasticities Cross-price elasticity of demand Cross-price elasticity of demand A measure of how responsive the demand of one good is to price changes of another good. It measures the percent change in quantity demanded that follows from a percent change in the price of another good. % Change in quantity demanded Cross-price elasticity of demand = % Change in price of another good Cross-price elasticity of demand provides useful information about the relationship between two goods. Egon Tripodi (Hertie) C7 Fall 2024 24 / 29  Elasticities Cross-price elasticity of demand Cross-price elasticity of demand A measure of how responsive the demand of one good is to price changes of another good. It measures the percent change in quantity demanded that follows from a percent change in the price of another good. % Change in quantity demanded Cross-price elasticity of demand = % Change in price of another good Cross-price elasticity of demand provides useful information about the relationship between two goods. Substitute goods: goods that can replace each other in consumption. Example: Coke and Pepsi Cross-price elasticity of demand is positive for substitutes: if the price of one increases, the demand for the other also increases. Egon Tripodi (Hertie) C7 Fall 2024 24 / 29  Elasticities Cross-price elasticity of demand Cross-price elasticity of demand A measure of how responsive the demand of one good is to price changes of another good. It measures the percent change in quantity demanded that follows from a percent change in the price of another good. % Change in quantity demanded Cross-price elasticity of demand = % Change in price of another good Cross-price elasticity of demand provides useful information about the relationship between two goods. Substitute goods: goods that can replace each other in consumption. Example: Coke and Pepsi Cross-price elasticity of demand is positive for substitutes: if the price of one increases, the demand for the other also increases. Complement goods: goods that are consumed together. Example: printers and ink cartridges Cross-price elasticity of demand is negative for complements: if the price of one increases, the demand for the other decreases. Egon Tripodi (Hertie) C7 Fall 2024 24 / 29  Elasticities Income elasticity of demand Income elasticity of demand A measure of how responsive the demand for a good is to changes in income. It measures the percent change in quantity demanded that follows from a percent change in income. % Change in quantity demanded Income elasticity of demand = % Change in income Egon Tripodi (Hertie) C7 Fall 2024 25 / 29  Elasticities Income elasticity of demand Income elasticity of demand A measure of how responsive the demand for a good is to changes in income. It measures the percent change in quantity demanded that follows from a percent change in income. % Change in quantity demanded Income elasticity of demand = % Change in income Income elasticity of demand helps us understand whether a good is normal or inferior. Egon Tripodi (Hertie) C7 Fall 2024 25 / 29  Elasticities Income elasticity of demand Income elasticity of demand A measure of how responsive the demand for a good is to changes in income. It measures the percent change in quantity demanded that follows from a percent change in income. % Change in quantity demanded Income elasticity of demand = % Change in income Income elasticity of demand helps us understand whether a good is normal or inferior. Normal goods: goods for which higher income leads to a higher demand. Example: organic food, cars Income elasticity is positive for normal goods: as income rises, demand for these products increases. Egon Tripodi (Hertie) C7 Fall 2024 25 / 29  Elasticities Income elasticity of demand Income elasticity of demand A measure of how responsive the demand for a good is to changes in income. It measures the percent change in quantity demanded that follows from a percent change in income. % Change in quantity demanded Income elasticity of demand = % Change in income Income elasticity of demand helps us understand whether a good is normal or inferior. Normal goods: goods for which higher income leads to a higher demand. Example: organic food, cars Income elasticity is positive for normal goods: as income rises, demand for these products increases. Inferior goods: goods for which higher income leads to a lower demand. Example: canned food, second-hand cars Income elasticity is negative for inferior goods: as income rises, demand for these products decreases. Egon Tripodi (Hertie) C7 Fall 2024 25 / 29  Elasticities Price elasticity of supply Price elasticity of supply A measure of how responsive sellers are to price changes. It measures the percent change in quantity supplied that follows from a percent price change. % Change in quantity supplied Price elasticity of supply = % Change in price Egon Tripodi (Hertie) C7 Fall 2024 26 / 29  Elasticities Price elasticity of supply Price elasticity of supply A measure of how responsive sellers are to price changes. It measures the percent change in quantity supplied that follows from a percent price change. % Change in quantity supplied Price elasticity of supply = % Change in price Price elasticity of supply is crucial for various stakeholders: firms, employees, governments, and more. It helps address questions like: Egon Tripodi (Hertie) C7 Fall 2024 26 / 29  Elasticities Price elasticity of supply Price elasticity of supply A measure of how responsive sellers are to price changes. It measures the percent change in quantity supplied that follows from a percent price change. % Change in quantity supplied Price elasticity of supply = % Change in price Price elasticity of supply is crucial for various stakeholders: firms, employees, governments, and more. It helps address questions like: How might Uber drivers adjust to higher fare prices during peak demand peri- ods? Egon Tripodi (Hertie) C7 Fall 2024 26 / 29  Elasticities Price elasticity of supply Price elasticity of supply A measure of how responsive sellers are to price changes. It measures the percent change in quantity supplied that follows from a percent price change. % Change in quantity supplied Price elasticity of supply = % Change in price Price elasticity of supply is crucial for various stakeholders: firms, employees, governments, and more. It helps address questions like: How might Uber drivers adjust to higher fare prices during peak demand peri- ods? How could oil exporters react to changes in oil prices due to geopolitical events? Egon Tripodi (Hertie) C7 Fall 2024 26 / 29  Elasticities Price elasticity of supply Price elasticity of supply A measure of how responsive sellers are to price changes. It measures the percent change in quantity supplied that follows from a percent price change. % Change in quantity supplied Price elasticity of supply = % Change in price Price elasticity of supply is crucial for various stakeholders: firms, employees, governments, and more. It helps address questions like: How might Uber drivers adjust to higher fare prices during peak demand peri- ods? How could oil exporters react to changes in oil prices due to geopolitical events? What might be the response of construction companies to rising housing prices? Egon Tripodi (Hertie) C7 Fall 2024 26 / 29  Elasticities Price elasticity of supply: determinants The unifying theme is flexibility of sellers. Egon Tripodi (Hertie) C7 Fall 2024 27 / 29  Elasticities Price elasticity of supply: determinants The unifying theme is flexibility of sellers. 1 Inventories =⇒ more elastic supply Example: Oil refineries can immediately dial up supply by selling stored inven- tories of gas. Egon Tripodi (Hertie) C7 Fall 2024 27 / 29  Elasticities Price elasticity of supply: determinants The unifying theme is flexibility of sellers. 1 Inventories =⇒ more elastic supply Example: Oil refineries can immediately dial up supply by selling stored inven- tories of gas. 2 Easily available variable inputs =⇒ more elastic supply Example: Bakeries can quickly adjust output based on the availability of flour and other common ingredients, whereas specialty manufacturers might struggle. Egon Tripodi (Hertie) C7 Fall 2024 27 / 29  Elasticities Price elasticity of supply: determinants The unifying theme is flexibility of sellers. 1 Inventories =⇒ more elastic supply Example: Oil refineries can immediately dial up supply by selling stored inven- tories of gas. 2 Easily available variable inputs =⇒ more elastic supply Example: Bakeries can quickly adjust output based on the availability of flour and other common ingredients, whereas specialty manufacturers might struggle. 3 Extra capacity =⇒ more elastic supply Example: A factory running at 50% capacity has more elastic supply than fac- tories running at 100% capacity. Egon Tripodi (Hertie) C7 Fall 2024 27 / 29  Elasticities Price elasticity of supply: determinants The unifying theme is flexibility of sellers. 1 Inventories =⇒ more elastic supply Example: Oil refineries can immediately dial up supply by selling stored inven- tories of gas. 2 Easily available variable inputs =⇒ more elastic supply Example: Bakeries can quickly adjust output based on the availability of flour and other common ingredients, whereas specialty manufacturers might struggle. 3 Extra capacity =⇒ more elastic supply Example: A factory running at 50% capacity has more elastic supply than fac- tories running at 100% capacity. 4 Easy entry and exit =⇒ more elastic supply Example: Food trucks have a more elastic supply compared to brick-and-mortar restaurants, as setting up and shutting down is easier. Egon Tripodi (Hertie) C7 Fall 2024 27 / 29  Elasticities Price elasticity of supply: determinants The unifying theme is flexibility of sellers. 1 Inventories =⇒ more elastic supply Example: Oil refineries can immediately dial up supply by selling stored inven- tories of gas. 2 Easily available variable inputs =⇒ more elastic supply Example: Bakeries can quickly adjust output based on the availability of flour and other common ingredients, whereas specialty manufacturers might struggle. 3 Extra capacity =⇒ more elastic supply Example: A factory running at 50% capacity has more elastic supply than fac- tories running at 100% capacity. 4 Easy entry and exit =⇒ more elastic supply Example: Food trucks have a more elastic supply compared to brick-and-mortar restaurants, as setting up and shutting down is easier. 5 More time =⇒ more elastic supply Example: Over longer periods, sectors like construction can adjust supply more easily, e.g., by acquiring land and permits. Egon Tripodi (Hertie) C7 Fall 2024 27 / 29 Next time Taxation Reasons for taxes Tax on sellers / buyers Tax incidence and its determinants Statutory equivalence of taxes (and when it does not hold) Price and quantity regulations Price regulation: price ceilings and floors Quantity regulation From taxes to spending: fiscal policy How do governments use tax money? Components of government revenue Progressive vs. regressive taxes Tax expenditures Expansionary vs. contractionary fiscal policy Counter-cyclical fiscal policy Government debt Egon Tripodi (Hertie) C7 Fall 2024 28 / 29 References Papers Jensen, Robert T. and Nolan H. Miller (Sept. 2008). “Giffen Behavior and Subsistence Consumption”. In: American Economic Review 98.4, pp. 1553–77. Images kamath ln (2007). Boiled White rice. Wikimedia Commons. Weinstein, Brett (2006). SC06 2006 Rolls-Royce Phantom. Wikimedia Commons. Egon Tripodi (Hertie) C7 Fall 2024 29 / 29  Economics I Week 10 Egon Tripodi Hertie School Egon Tripodi (Hertie) C7 Fall 2024 1 / 39  Recap & Roadmap Recap & Roadmap Egon Tripodi (Hertie) C7 Fall 2024 2 / 39  Recap & Roadmap Recap Industrial revolution Hockey stick of GDP per capita The beginning of the Industrial Revolution The Malthusian model The Malthusian view Production function, marginal and average product of labor Technological innovation and production function Wages in the Malthusian model High-brow issues with the Malthusian model In defense of Malthus Theories of the Industrial Revolution Mokyr: a culture of growth Clark: an ”evolutionary” approach Pomeranz: coal and the New World Important theories in contemporary comparative development Galor: Unified Growth Theory Acemoglu and Robinson: extractive vs. inclusive institutions Egon Tripodi (Hertie) C7 Fall 2024 3 / 39  Recap & Roadmap Roadmap for today Household finance: borrowing and lending Banks Egon Tripodi (Hertie) C7 Fall 2024 4 / 39  Household finance: borrowing and lending Household finance: borrowing and lending Egon Tripodi (Hertie) C7 Fall 2024 5 / 39  Household finance: borrowing and lending Motivation All agents in the economy (consumers, firms, governments) face uncertainty and fluctuation in their income Their needs also fluctuate but not necessarily in the same way as income Examples: An unexpected illness could require expensive medication immediately A friend suddenly says that she can offer a free accommodation at the Bahamas if you travel next month A now-or-never investment opportunity Wedding scheduled for next year A wild fire that damages the electricity grid So how do we address asynchronous fluctuations in income and needs? Egon Tripodi (Hertie) C7 Fall 2024 6 / 39  Household finance: borrowing and lending Motivation All agents in the economy (consumers, firms, governments) face uncertainty and fluctuation in their income Their needs also fluctuate but not necessarily in the same way as income Examples: An unexpected illness could require expensive medication immediately A friend suddenly says that she can offer a free accommodation at the Bahamas if you travel next month A now-or-never investment opportunity Wedding scheduled for next year A wild fire that damages the electricity grid So how do we address asynchronous fluctuations in income and needs? Borrowing and saving! Banks play a key role in this (more on this later) Egon Tripodi (Hertie) C7 Fall 2024 6 / 39  Household finance: borrowing and lending Intertemporal decision-making There are 2 time periods: now (period 1) or later (period 2) Endowment: $0 in P1, $100 in P2 Note: for notation simplicity, we consider the case of no inflation in this lecture The agent needs to choose how much to spend now (C1 ) and later (C2 ) Egon Tripodi (Hertie) C7 Fall 2024 7 / 39  Household finance: borrowing and lending Intertemporal decision-making There are 2 time periods: now (period 1) or later (period 2) Endowment: $0 in P1, $100 in P2 Note: for notation simplicity, we consider the case of no inflation in this lecture The agent needs to choose how much to spend now (C1 ) and later (C2 ) If interest rate r is 10%, $100 in P2 is worth $91 in P1 $100 ≈ (1 + 0.1) · $91 If P2 is one year later from now, 10% is the annual interest rate: repayment interest rate = −1 principal $100 = −1 $91 = 0.1 = 10% Egon Tripodi (Hertie) C7 Fall 2024 7 / 39  Household finance: borrowing and lending Intertemporal decision-making There are 2 time periods: now (period 1) or later (period 2) Endowment: $0 in P1, $100 in P2 Note: for notation simplicity, we consider the case of no inflation in this lecture The agent needs to choose how much to spend now (C1 ) and later (C2 ) Budget constraint: C2 = $100 − (1 + r )C1 r = 0.1 The slope of the budget con- straint is −1.1 Egon Tripodi (Hertie) C7 Fall 2024 7 / 39  Household finance: borrowing and lending Intertemporal decision-making There are 2 time periods: now (period 1) or later (period 2) Endowment: $0 in P1, $100 in P2 Note: for notation simplicity, we consider the case of no inflation in this lecture The agent needs to choose how much to spend now (C1 ) and later (C2 ) But if r is higher (78%), $100 in P2 is worth only $56 in P1: $100 ≈ (1 + 0.78) · $56 New budget constraint: C2 = $100 − (1 + r )C1 r = 0.78 The slope of the new budget constraint is −1.78 Egon Tripodi (Hertie) C7 Fall 2024 7 / 39  Household finance: borrowing and lending Smoothing and decreasing marginal returns to consumption Smoothing: economic agents tend to prefer to smooth out consumption in- stead of consuming everything later and nothing now This holds due to the diminishing marginal returns to consumption: the value of an additional unit of consumption declines as consumption increases With the diminishing marginal returns to consumption, indif- ference curve is bowed toward the origin (convex): the more goods in the present, the less the agent values an additional good now relative to one in the future Egon Tripodi (Hertie) C7 Fall 2024 8 / 39  Household finance: borrowing and lending Smoothing and decreasing marginal returns to consumption Smoothing: economic agents tend to prefer to smooth out consumption in- stead of consuming everything later and nothing now This holds due to the diminishing marginal returns to consumption: the value of an additional unit of consumption declines as consumption increases The point of tangency between the indifference curve and the budget constraint (F) shows how much the agent decides to spend now and later given the income stream and credit con- ditions Egon Tripodi (Hertie) C7 Fall 2024 8 / 39  Household finance: borrowing and lending Borrowing Borrowers trade future consumption for present consumption A higher interest rate makes present consumption relatively more expensive So, a higher interest rate reduces lifetime utility = a lower indifference curve Egon Tripodi (Hertie) C7 Fall 2024 9 / 39  Household finance: borrowing and lending Borrowing Borrowers trade future consumption for present consumption A higher interest rate makes present consumption relatively more expensive So, a higher interest rate reduces lifetime utility = a lower indifference curve Budget constraint becomes steeper; G provides less utility than E Egon Tripodi (Hertie) C7 Fall 2024 9 / 39  Household finance: borrowing and lending Determinants of access to credit markets Creditworthiness and financial history Credit score (625-850) vs. mortgage rate in the US (p50 and p90) (Marte 2016) Employment type and income Availability of collateral (a borrower’s property pledged to secure a loan) Local access to formal finance Regulation Market conditions Egon Tripodi (Hertie) C7 Fall 2024 10 / 39  Household finance: borrowing and lending Detour: lending as a principal-agent problem (1) Lending is risky, and borrowers often have more information about their project’s viability and their own effort than lenders Conflict of interest arises: Borrowers may exert less effort or invest in poor projects, risking the lender’s capital Lending is a principal–agent relationship: the lender (the principal) would like to ensure that the borrower (the agent) repays a loan, but cannot enforce this directly through a contract market failures due to contract incompleteness ← Moral hazard Egon Tripodi (Hertie) C7 Fall 2024 11 / 39  Household finance: borrowing and lending Detour: lending as a principal-agent problem (2) To address this issue, lenders balance between demanding higher interest rates from riskier borrowers, while keeping interest rates sufficiently low to not make default more attractive than paying back require borrowers to put some of their own wealth at stake (in the form of collateral or equity) But this leads to credit rationing: borrowers with less wealth face unfavorable lending terms or are denied loans, as they cannot provide enough collateral or equity Credit-excluded individuals can’t secure loans at all Credit-constrained individuals secure loans at high costs Credit rationing disproportionately affects less wealthy borrowers who typically need the loans the most, limiting their economic opportunities and perpetuating inequality Egon Tripodi (Hertie) C7 Fall 2024 12 / 39  Household finance: borrowing and lending Determinants of access to credit markets Creditworthiness and financial history Credit score vs. mortgage rate in the US (Marte 2016) Employment type and income Availability of collateral (a borrower’s property pledged to secure a loan) Availability of formal finance Regulation Market conditions Regulation and market conditions were important factors in the unfolding of the subprime mortgage crisis in 2007-2008 Egon Tripodi (Hertie) C7 Fall 2024 13 / 39  Household finance: borrowing and lending Subprime mortgage crisis1 Deregulation: the Glass-Steagall Act, which separated commercial and in- vestment banking, was repealed in 1999. This allowed banks to engage in riskier financial activities Market conditions: the booming housing market provided an incentive for banks to expand lending to high-risk (subprime) individuals Subprime mortgage lending was very high in years preceding the crisis (FCIC 2011) Crisis: many of those high-risk mortgages defaulted, leading to the housing bubble burst and a broader economic downturn 1 Discussion based on Duignan (2023) (link) Egon Tripodi (Hertie) C7 Fall 2024 14 / 39  Household finance: borrowing and lending Securitization of mortgages (1) Idea Pool individual mortgages to create “securities”, mitigating individual borrower risks Sell these securities to investors, essentially offering them the future payment streams in exchange for immediate capital Securities can be continuously traded in financial markets Pros Frees up capital for mortgage originators, enabling them to issue new loans Creates opportunities for small investors to access ”low-risk” investments with potentially higher returns compared to other fixed-income assets (e.g. bonds) Enhances liquidity in the housing finance system and can lower borrowing costs for homeowners Egon Tripodi (Hertie) C7 Fall 2024 15 / 39  Household finance: borrowing and lending Securitization of mortgages (2) Cons Asset composition can lack transparency, obscuring the true risk profile The transfer of default risk can lead to moral hazard, with originators (banks) less motivated to check borrower’s creditworthiness Risk amplification: rising housing prices inflate security values, enabling higher bank borrowing and lending, which can further drive up prices, potentially leading to a housing bubble and financial instability Securitization and the subprime mortgage crisis Overly optimistic beliefs about continual increases in housing prices led to aggressive lending practices Incentives to increase lending volume made credit rationing too low: credit was extended to borrowers who should not have received credit Egon Tripodi (Hertie) C7 Fall 2024 16 / 39  Household finance: borrowing and lending Saving Savers trade present consumption for future consumption Egon Tripodi (Hertie) C7 Fall 2024 17 / 39  Household finance: borrowing and lending Saving Savers trade present consumption for future consumption In this example, saver has an endowment of $100 now Better investment opportunities, which have higher interest rates, increase lifetime utility = a higher indifference curve Budget constraint becomes steeper; J provides more utility than H Egon Tripodi (Hertie) C7 Fall 2024 17 / 39  Household finance: borrowing and lending Borrowing to invest (1) Suppose Marco has an endowment of $100 now Egon Tripodi (Hertie) C7 Fall 2024 18 / 39  Household finance: borrowing and lending Borrowing to invest (1) Suppose Marco has an endowment of $100 now He has an investment opportunity that yields 50% and has no access to loans Egon Tripodi (Hertie) C7 Fall 2024 18 / 39  Household finance: borrowing and lending Borrowing to invest (1) Suppose Marco has an endowment of $100 now He has an investment opportunity that yields 50% and has no access to loans Budget constraint: C2 = |$150 {z} −1.5C1 C2 when C1 =0 The opportunity cost of consuming $1 now is $1.5 of future consumption, which is what Marco would earn by in- vesting $1 Egon Tripodi (Hertie) C7 Fall 2024 18 / 39  Household finance: borrowing and lending Borrowing to invest (1) Suppose Marco has an endowment of $100 now He has an investment opportunity that yields 50% and has no access to loans Budget constraint: C2 = |$150 {z} −1.5C1 C2 when C1 =0 The opportunity cost of consuming $1 now is $1.5 of future consumption, which is what Marco would earn by in- vesting $1 Marco invests some of the endowment and consumes at point K Egon Tripodi (Hertie) C7 Fall 2024 18 / 39  Household finance: borrowing and lending Borrowing to invest (2) Now, suppose that Marco also has access to loans at 10% interest rate No-Ponzi-Scheme condition: he can borrow at most what his endowment generates if invested Egon Tripodi (Hertie) C7 Fall 2024 19 / 39  Household finance: borrowing and lending Borrowing to invest (2) Now, suppose that Marco also has access to loans at 10% interest rate No-Ponzi-Scheme condition: he can borrow at most what his endowment generates if invested His investment opportunity yields more than the interest rate (50% > 10%) So, he would be better off by investing all his endowment to receive $150 in the future, and borrow for current consumption Budget constraint and the feasible set expands: C2 = |$150 {z} −1.1C1 C2 when C1 =0 Egon Tripodi (Hertie) C7 Fall 2024 19 / 39  Household finance: borrowing and lending Borrowing to invest (2) Now, suppose that Marco also has access to loans at 10% interest rate No-Ponzi-Scheme condition: he can borrow at most what his endowment generates if invested His investment opportunity yields more than the interest rate (50% > 10%) So, he would be better off by investing all his endowment to receive $150 in the future, and borrow for current consumption Budget constraint and the feasible set expands: C2 = |$150 {z} −1.1C1 C2 when C1 =0 With a loan access, opportunity cost of consuming $1 now is lower and equals $1.1 of future consumption, as Marco just needs to pay the interest rate Marco’s new optimal point L yields more than K Egon Tripodi (Hertie) C7 Fall 2024 19 / 39  Household finance: borrowing and lending Determinants of access to investment markets Financial literacy: capacity to process economic information and make in- formed financial decisions is crucial for sound investment decisions (Lusardi and Mitchell 2014) Partly, this is reflected in the Stock Market Participation puzzle. In the NL, a move from the 25th to the 75th percentile of financial literacy correlates with a €80,000 increase in net worth and a 17-30% higher likelihood of stock market participation and retirement planning (van Rooij et al. 2012) Simulations suggest that financial literacy can explain more than half of the observed wealth inequality in the US (Lusardi, Michaud, et al. 2017) Regulatory environment for investors: a stable, transparent, and predictable regulatory framework, combined with rule of law, enhances investment oppor- tunities (OECD 2006) Political stability: political unrest or uncertainty leads to less secure property rights, reducing investment opportunities (Svensson 1998) Egon Tripodi (Hertie) C7 Fall 2024 20 / 39  Banks Banks Egon Tripodi (Hertie) C7 Fall 2024 21 / 39  Banks Commercial banks Banks are central to household borrowing and lending Commercial banks are firms that make profits through lending and borrowing activities They use deposits of their customers to make loans or investments Note: the boundaries between commercial and investment banking are better defined now than they were in 2007, before the financial crisis: commercial banks today mostly invest in safe assets like government bonds Assets ($ million) Liabilities and Equity ($ million) Assets Liabilities Cash 100 Deposits from customers 600 Loans to customers 500 Bank loans 150 Government bonds 200 Other liabilities 50 Other assets 50 Equity 100 Total Assets 850 Total Liabilities and Equity 850 Egon Tripodi (Hertie) C7 Fall 2024 22 / 39  Banks Share of domestic government bonds and loans in the Euro-area banks’ assets Euro-area banks’ exposure to respective domestic government until Dec 2022 (Mai 2023) Note: Capital = Equity = Assets − Liabilities Egon Tripodi (Hertie) C7 Fall 2024 23 / 39  Banks Base money vs. bank money Base money is the legal tender including: Cash held by households, firms, and banks Balances held by commercial banks at the central bank (reserves) In addition to this, commercial banks can effectively create money when they make loans. This is called bank money Example: when a person borrows $100 from a bank, the bank doesn’t use existing base money to make this loan; instead, it generates a new deposit in the borrower’s account for $100. This is new bank money Base money remains essential, as the bank has to transfer base money when the loan is spent In practice, banks make many transactions to one another, most cancelling each other out, so they do not need to have available the base money to cover all transactions Broad money includes both bank money and base money, representing the total money supply circulating in the economy Egon Tripodi (Hertie) C7 Fall 2024 24 / 39  Banks Money market To manage daily transactions, commercial banks regularly borrow base money from each other in the money market The price of borrowing base money from other financial institutions is the short-term interest rate This price is determined by: Demand for base money: amount of transactions commercial banks have to make (the fraction that isn’t cleared with bank money between banks) Supply of base money: set by the central bank Egon Tripodi (Hertie) C7 Fall 2024 25 / 39  Banks Policy and bank lending rates Central bank sets the policy (interest) rate through supply of base money. This rate applies to banks that borrow base money from each other, and from the central bank Policy rate is also called base rate or official rate This has an effect on bank lending rate, which is the average interest rate charged by commercial banks to firms and households Bank lending rate is also called market interest rate Different from and typically higher than the short-term interest rate Because banks need to make a profit, this rate will typically be above the policy interest rate: the difference is the markup or spread on commercial lending In the UK, the policy rate was 0.5% in 2014; bank lending rate was ≈3% Generally the bank lending rate and the short term interest rate move with the policy rate Egon Tripodi (Hertie) C7 Fall 2024 26 / 39  Banks Maturity transformation Banks provide a service to the economy known as maturity transformation2 , which involves: Accepting deposits which can be withdrawn on demand (short-term) Making loans which have a fixed repayment date, often in the long-term (e.g., 30-year mortgages) Maturity transformation bridges the gap between short-term savers and long- term borrowers, facilitating long-term investments and planning in the economy However, it exposes banks to risks: Liquidity risk: the risk that an asset cannot be exchanged for cash rapidly enough to prevent a financial loss Default risk: the risk that loans will not be repaid 2 Maturity means the length of a loan Egon Tripodi (Hertie) C7 Fall 2024 27 / 39  Banks Long-term assets and Present Value (PV) Even though long-term assets are not as liquid as cash deposits, they can be traded. Banks can liquidate them at their current market price if needed The price of such assets is determined by the risk-adjusted stream of future incomes. This concept is captured by the Present Value (PV) Egon Tripodi (Hertie) C7 Fall 2024 28 / 39  Banks Deriving PV and NPV of an asset (1) What is the value of an asset that gives you $100 in a year’s time? Egon Tripodi (Hertie) C7 Fall 2024 29 / 39  Banks Deriving PV and NPV of an asset (1) What is the value of an asset that gives you $100 in a year’s time? Start simple, by assuming no default risk PV equals the amount of money you would earn in a year’s time if you put $100 in the bank today Suppose the annual interest rate r is 6%. Then: $100 $100 PV = = = $94.34 1+r 1.06 Egon Tripodi (Hertie) C7 Fall 2024 29 / 39  Banks Deriving PV and NPV of an asset (1) What is the value of an asset that gives you $100 in a year’s time? Start simple, by assuming no default risk PV equals the amount of money you would earn in a year’s time if you put $100 in the bank today Suppose the annual interest rate r is 6%. Then: $100 $100 PV = = = $94.34 1+r 1.06 Similarly, if an asset gives you $100 in t years’ time, it’s value today is: $100 PV = (1 + r )t Egon Tripodi (Hertie) C7 Fall 2024 29 / 39  Banks Deriving PV and NPV of an asset (2) Now, suppose an asset gives a payment each year for T years, paying Xt in year t, starting next year So it pays X1 in 1 year’s time, X2 in 2 years’ time, etc. Then, each payment Xt has to be discounted according to the interest rate r and how far in the future it is The sum of these discounted payments is its present value: X1 X2 XT PV = + +... + (1 + r )1 (1 + r )2 (1 + r )T Egon Tripodi (Hertie) C7 Fall 2024 30 / 39  Banks Deriving PV and NPV of an asset (2) Now, suppose an asset gives a payment each year for T years, paying Xt in year t, starting next year So it pays X1 in 1 year’s time, X2 in 2 years’ time, etc. Then, each payment Xt has to be discounted according to the interest rate r and how far in the future it is The sum of these discounted payments is its present value: X1 X2 XT PV = + +... + (1 + r )1 (1 + r )2 (1 + r )T Net Present Value (NPV) is the value of the asset, accounting for its cost: NPV = PV − c Investors will seek assets with positive NPV, as this means that the expected profits from the asset are worth more than the cost Egon Tripodi (Hertie) C7 Fall 2024 30 / 39  Banks Illustration: price of a bond (1) A bond is a financial instrument where the issuer borrows funds from the bondholder and promises to repay over a specific duration. Bonds normally last a predetermined amount of time (maturity) and offer two forms of payment Coupons C paid every period until maturity (every year, every quarter, etc.) Face value F paid when the bond matures The price of a bond depends on its present value Suppose a bond has a maturity of T years and pays coupons every year. Then, C C C F PV = + +... + + (1 + r )1 (1 + r )2 (1 + r )T (1 + r )T | {z } | {z } Coupons Face value Egon Tripodi (Hertie) C7 Fall 2024 31 / 39  Banks Illustration: price of a bond (2) With F = $1000, C = $10, T = 10, r = 5%: 10 X $10 $1000 PV = t + 10 = $691.13 t=1 (1.05) 1.05 Egon Tripodi (Hertie) C7 Fall 2024 32 / 39  Banks Illustration: price of a bond (2) With F = $1000, C = $10, T = 10, r = 5%: 10 X $10 $1000 PV = t + 10 = $691.13 t=1 (1.05) 1.05 Now, suppose that the market suddenly expects that there is 10% chance that the bond-issuing country A will go bankrupt in 2 years time What happens to the price of the government bonds? Egon Tripodi (Hertie) C7 Fall 2024 32 / 39  Banks Illustration: price of a bond (2) With F = $1000, C = $10, T = 10, r = 5%: 10 X $10 $1000 PV = t + 10 = $691.13 t=1 (1.05) 1.05 Now, suppose that the market suddenly expects that there is 10% chance that the bond-issuing country A will go bankrupt in 2 years time What happens to the price of the government bonds? To account for this default risk, the income stream after two years needs to be discounted by the 90% probability that country A will not go bankrupt: 10 $10 X $10 $1000 PV = + 0.9 t + 0.9 10 = $622.97 (1.05) t=2 (1.05) 1.05 Egon Tripodi (Hertie) C7 Fall 2024 32 / 39  Banks Bank runs due to asset depreciation Bank runs may occur when depositors fear insolvency and withdraw funds rapidly Silicon Valley Bank, 2023 American Union Bank, 1932 Egon Tripodi (Hertie) C7 Fall 2024 33 / 39  Banks Bank runs due to asset depreciation Bank runs may occur when depositors fear insolvency and withdraw funds rapidly Banks do maturity transformation by offering long-term loans, which leaves them at any time with insufficient liquid cash to cover mass withdrawals Any increase in withdrawals diminishes a bank’s liquidity (base money), forcing it to sell assets at lower values and incur big losses Assets can depreciate, e.g. due to a (bond) crisis or central banks increasing policy rates to manage inflation This depreciation makes depositors worried that now it’s even more likely for the bank to be insolvent with increases in deposit withdrawals, potentially triggering more withdrawals and creating a self-perpetuating cycle Egon Tripodi (Hertie) C7 Fall 2024 33 / 39  Banks Game theory of bank runs Other bank customers Keep money Withdraw in the bank -10 (Bank run) ✓ 0 (Don’t earn interest) Withdraw -10 (Bank run) ✓ -20 (Lose savings) You Keep money -20 (Lose savings) 10 (Earn interest) ✓ in the bank 0 (Don’t earn interest) 10 (Earn interest) ✓ Bank run can be seen as a coordination game (recall Week 5) There are 2 Nash equilibria: Everyone rushes to the bank to withdraw before the bank collapses, resulting in a bank run No one withdraws, bank remains stable - everyone earns interest Major asset depreciation episodes don’t change the multiple equilibria nature of this game, but they can cause a shift on which equilibrium is played Egon Tripodi (Hertie) C7 Fall 2024 34 / 39  Banks Preventing bank runs Deposit insurance Protects depositors’ funds up to a certain amount (€100k in the EU, $250k in the US, none in NZ) Increase banks’ moral hazard (taking on more risk than without insurance) But because it’s partial insurance, depositors still have incentives to punish banks that take excessive risks In bad times, it reduces panic among depositors and prevents the cascade effect of withdrawals Egon Tripodi (Hertie) C7 Fall 2024 35 / 39  Banks Preventing bank runs Deposit insurance Protects depositors’ funds up to a certain amount (€100k in the EU, $250k in the US, none in NZ) Increase banks’ moral hazard (taking on more risk than without insurance) But because it’s partial insurance, depositors still have incentives to punish banks that take excessive risks In bad times, it reduces panic among depositors and prevents the cascade effect of withdrawals Central bank facilities Central banks can serve as a lender of last resort and extend lines of credit to struggling banks at a discount rate Example: borrowing at the discount window from the Fed soared to $153bil on March 15, 2023, after Silicon Valley Bank failed (Lee and Wessel 2023) However, banks may hesitate to use this facility as it signals weakness Egon Tripodi (Hertie) C7 Fall 2024 35 / 39  Banks Preventing bank runs Deposit insurance Protects depositors’ funds up to a certain amount (€100k in the EU, $250k in the US, none in NZ) Increase banks’ moral hazard (taking on more risk than without insurance) But because it’s partial insurance, depositors still have incentives to punish banks that take excessive risks In bad times, it reduces panic among depositors and prevents the cascade effect of withdrawals Central bank facilities Central banks can serve as a lender of last resort and extend lines of credit to struggling banks at a discount rate Example: borrowing at the discount window from the Fed soared to $153bil on March 15, 2023, after Silicon Valley Bank failed (Lee and Wessel 2023) However, banks may hesitate to use this facility as it signals weakness Bank capital requirements Regulations ensuring banks maintain adequate capital (equity) relative to assets Enhances depositor confidence and curbs excessive lending risks Constains lending ← during recessions, this potentially slows recovery Egon Tripodi (Hertie) C7 Fall 2024 35 / 39 Qualifying parts of the ”mandatory” readings: Subsection 10.13 This subsection requires knowledge of how Gini coefficients are derived, which is useful but not necessary for the exam Egon Tripodi (Hertie) C7 Fall 2024 36 / 39 Next time Inflation and money Inflation A common measure of inflation: CPI Alternative measures of inflation Real vs. nominal interest rates Money illusion Three functions of money Hyperinflation Costs of inflation Central Banks Role of Central Banks Price stability: the main mandate of central banks Dual mandate: prices and employment Central bank balance sheets Direct/indirect instruments of monetary policy Monetary transmission mechanisms Egon Tripodi (Hertie) C7 Fall 2024 37 / 39 References Papers Lusardi, Annamaria, Pierre-Carl Michaud, et al. (2017). “Optimal Financial Knowledge and Wealth Inequality”. In: Journal of Political Economy 125.2, pp. 431–477. Lusardi, Annamaria and Olivia S. Mitchell (2014). “The Economic Importance of Financial Literacy: Theory and Evidence”. In: Journal of Economic Literature 52.1, pp. 5–44. Svensson, Jakob (1998). “Investment, property rights and political instability: Theory and evidence”. In: European Economic Review 42.7, pp. 1317–1341. van Rooij, Maarten C.J. et al. (2012). “Financial Literacy, Retirement Planning and Household Wealth*”. In: The Economic Journal 122.560, pp. 449–478. Egon Tripodi (Hertie) C7 Fall 2024 38 / 39 References New articles, reports, and encyclopedia entries Duignan, Brian (2023). “Financial crisis of 2007–08”. In: Encyclopedia Britannica. Lee, James and David Wessel (2023). “What did the Fed do after Silicon Valley Bank and Signature Bank failed?” In: The Brookings Institution. Mai, Heike (2023). “Sovereign exposures of European banks – revisited”. In: Deutsche Bank Research. Marte, Jonnelle (2016). “Here’s how much your credit score affects your mortgage rate”. In: The Washington Post. Books FCIC (2011). The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States. U.S. Government Printing Office. OECD (2006). Policy Framework for Investment: A Review of Good Practices. OECD Publishing. Images Bank Run on American Union Bank (1932). The National Archives. Hosea-Small, Brittany (2023). Customers line up outside of the Silicon Valley Bank headquarters. Reuters. Egon Tripodi (Hertie) C7 Fall 2024 39 / 39  Economics I Week 3 Egon Tripodi Hertie School Egon Tripodi (Hertie) C7 Fall 2024 1 / 37  Recap & Roadmap Recap & Roadmap Egon Tripodi (Hertie) C7 Fall 2024 2 / 37  Recap & Roadmap Recap Demand Understanding individual demand The law of demand (and exceptions) Aggregation of demand: from individual to market demand Factors influencing shifts in demand curve Supply Individual supply as a production plan How prices are determined under perfect competition Aggregation of supply & factors influencing shifts in supply curve Markets Understanding market equilibrium Supply and demand imbalances in disequilibrium Elasticities Price elasticity of demand Cross-price and income elasticity of demand Elasticity of supply Egon Tripodi (Hertie) C7 Fall 2024 3 / 37  Recap & Roadmap Today’s outline 1 Taxation 2 Price and quantity regulations 3 Revenue and fiscal policy Egon Tripodi (Hertie) C7 Fall 2024 4 / 37  Taxation Taxation Egon Tripodi (Hertie) C7 Fall 2024 5 / 37  Taxation Reasons for taxes There are 2 main reasons for taxation: 1 Pay government bills (health, defense, interest on national debt...) The most important source of government revenue in most countries 2 Influence market outcomes Examples: redistribution, environmental taxes to reduce pollution Egon Tripodi (Hertie) C7 Fall 2024 6 / 37  Taxation Reasons for taxes There are 2 main reasons for taxation: 1 Pay government bills (health, defense, interest on national debt...) The most important source of government revenue in most countries 2 Influence market outcomes Examples: redistribution, environmental taxes to reduce pollution Taxes can also be negative: these are called subsidies. Subsidy Subsidy is a payment made by the government to those who make a specific choice Egon Tripodi (Hertie) C7 Fall 2024 6 / 37  Taxation Tax on sellers Tax shifts the supply curve up Egon Tripodi (Hertie) C7 Fall 2024 7 / 37  Taxation Tax on sellers Tax shifts the supply curve up Quantity sold decreases (1.4mil → 1.2mil) Prices for buyers increase ($1.10 → $1.30) Prices for sellers decrease ($1.10 → $1.00) Egon Tripodi (Hertie) C7 Fall 2024 7 / 37  Taxation Tax on sellers Tax shifts the supply curve up Quantity sold decreases (1.4mil → 1.2mil) Prices for buyers increase ($1.10 → $1.30) Prices for sellers decrease ($1.10 → $1.00) Consumer bears 20 cents of the tax and sellers 10 cents (r.t. no tax eq.) Egon Tripodi (Hertie) C7 Fall 2024 7 / 37  Taxation Tax on sellers Tax shifts the supply curve up Quantity sold decreases (1.4mil → 1.2mil) Prices for buyers increase ($1.10 → $1.30) Prices for sellers decrease ($1.10 → $1.00) Gov revenue = Tax amount × Quantity = $0.30 × 1, 200, 000 = $360, 000 Egon Tripodi (Hertie) C7 Fall 2024 7 / 37  Taxation Tax burdens Statutory burden The burden of being assigned by the government to send a tax payment. Egon Tripodi (Hertie) C7 Fall 2024 8 / 37  Taxation Tax burdens Statutory burden The burden of being assigned by the government to send a tax payment. Economic burden The burden created by the change in after-tax prices faced by buyers and sellers. Egon Tripodi (Hertie) C7 Fall 2024 8 / 37  Taxation Tax burdens Statutory burden The burden of being assigned by the government to send a tax payment. Economic burden The burden created by the change in after-tax prices faced by buyers and sellers. Statutory burden ̸= economic burden. In the example above: Statutory burden is entirely on sellers, as they are directly taxed But economic burden is borne both by sellers (who receive less) and buyers (who pay more) Egon Tripodi (Hertie) C7 Fall 2024 8 / 37  Taxation Tax burdens Statutory burden The burden of being assigned by the government to send a tax payment. Economic burden The burden created by the change in after-tax prices faced by buyers and sellers. Statutory burden ̸= economic burden. In the example above: Statutory burden is entirely on sellers, as they are directly taxed But economic burden is borne both by sellers (who receive less) and buyers (who pay more) Tax incidence The division of the economic burden of a tax between buyers and sellers. Egon Tripodi (Hertie) C7 Fall 2024 8 / 37  Taxation Tax burdens Statutory burden The burden of being assigned by the government to send a tax payment. Economic burden The burden created by the change in after-tax prices faced by buyers and sellers. Statutory burden ̸= economic burden. In the example above: Statutory burden is entirely on sellers, as they are directly taxed But economic burden is borne both by sellers (who receive less) and buyers (who pay more) Tax incidence The division of the economic burden of a tax between buyers and sellers. Tax incidence depends on (price) elasticities of demand and supply (more on this later) Egon Tripodi (Hertie) C7 Fall 2024 8 / 37  Taxation Tax on buyers Tax shifts the demand curve down Egon Tripodi (Hertie) C7 Fall 2024 9 / 37  Taxation Tax on buyers Tax shifts the demand curve down Quantity sold decreases (1.4mil → 1.2mil) Prices for buyers increase ($1.10 → $1.30) Prices for sellers decrease ($1.10 → $1.00) Egon Tripodi (Hertie) C7 Fall 2024 9 / 37  Taxation Tax on buyers Tax shifts the demand curve down Quantity sold decreases (1.4mil → 1.2mil) Prices for buyers increase ($1.10 → $1.30) Prices for sellers decrease ($1.10 → $1.00) Consumer bears 20 cents of the tax and sellers 10 cents (r.t. no tax eq.) Egon Tripodi (Hertie) C7 Fall 2024 9 / 37  Taxation Tax on buyers Tax shifts the demand curve down Quantity sold decreases (1.4mil → 1.2mil) Prices for buyers increase ($1.10 → $1.30) Prices for sellers decrease ($1.10 → $1.00) Gov. revenue = Tax amount × Quantity = $0.30 × 1, 200, 000 = $360, 000 Egon Tripodi (Hertie) C7 Fall 2024 9 / 37  Taxation What determines tax incidence? Tax incidence depends on buyers’ and sellers’ ability to avoid taxes This is captured by the price elasticity of demand/supply Egon Tripodi (Hertie) C7 Fall 2024 10 / 37  Taxation What determines tax incidence? Tax incidence depends on buyers’ and sellers’ ability to avoid taxes This is captured by the price elasticity of demand/supply Supply is more elastic → sellers bear a smaller share of the economic burden Elastic supply Egon Tripodi (Hertie) C7 Fall 2024 10 / 37  Taxation What determines tax incidence? Tax incidence depends on buyers’ and sellers’ ability to avoid taxes This is captured by the price elasticity of demand/supply Supply is more elastic → sellers bear a smaller share of the economic burden Demand is more elastic → buyers bear a smaller share of the economic burden Elastic supply Elastic demand Egon Tripodi (Hertie) C7 Fall 2024 10 / 37  Taxation Statutory equivalence of taxes Notice that the tax burden and revenue are identical in the examples of tax on buyers vs. sellers Quantity sold: 1.4mil → 1.2mil Prices for buyers: $1.10 → $1.30 Prices for sellers: $1.10 → $1.00 Revenue = $360, 000 Egon Tripodi (Hertie) C7 Fall 2024 11 / 37  Taxation Statutory equivalence of taxes Notice that the tax burden and revenue are identical in the examples of tax on buyers vs. sellers Quantity sold: 1.4mil → 1.2mil Prices for buyers: $1.10 → $1.30 Prices for sellers: $1.10 → $1.00 Revenue = $360, 000 Statutory equivalence of taxes: whether government imposes a tax on con- sumers or sellers does not matter. Egon Tripodi (Hertie) C7 Fall 2024 11 / 37  Taxation Statutory equivalence of taxes Notice that the tax burden and revenue are identical in the examples of tax on buyers vs. sellers Quantity sold: 1.4mil → 1.2mil Prices for buyers: $1.10 → $1.30 Prices for sellers: $1.10 → $1.00 Revenue = $360, 000 Statutory equivalence of taxes: whether government imposes a tax on con- sumers or sellers does not matter. Then, how do governments choose which side of the market to tax? Egon Tripodi (Hertie) C7 Fall 2024 11 / 37  Taxation Statutory equivalence of taxes Notice that the tax burden and revenue are identical in the examples of tax on buyers vs. sellers Quantity sold: 1.4mil → 1.2mil Prices for buyers: $1.10 → $1.30 Prices for sellers: $1.10 → $1.00 Revenue = $360, 000 Statutory equivalence of taxes: whether government imposes a tax on con- sumers or sellers does not matter. Then, how do governments choose which side of the market to tax? Efficiency: ease of collection and administration Example: payroll taxes are often paid by the employer, as it’s easier to manage a smaller number of employers than a large number of employees Egon Tripodi (Hertie) C7 Fall 2024 11 / 37  Taxation Statutory equivalence of taxes Notice that the tax burden and revenue are identical in the examples of tax on buyers vs. sellers Quantity sold: 1.4mil → 1.2mil Prices for buyers: $1.10 → $1.30 Prices for sellers: $1.10 → $1.00 Revenue = $360, 000 Statutory equivalence of taxes: whether government imposes a tax on con- sumers or sellers does not matter. Then, how do governments choose which side of the market to tax? Efficiency: ease of collection and administration Example: payroll taxes are often paid by the employer, as it’s easier to manage a smaller number of employers than a large number of employees Fairness: moral and social implications of taxation Example: tourist taxes are imposed to compensate for tourists utilizing local resources, given they don’t contribute through regular local taxes Example: carbon taxes on producers penalize high-emission production, mak- ing companies ”pay” for their environmental impact and discouraging harmful behavior Egon Tripodi (Hertie) C7 Fall 2024 11 / 37  Taxation When statutory equivalence does not hold We focus on cases where statutory equivalence holds, but this is not always true Market structure matters Egon Tripodi (Hertie) C7 Fall 2024 12 / 37  Taxation When statutory equivalence does not hold We focus on cases where statutory equivalence holds, but this is not always true Market structure matters Cases where statutory equivalence may not hold: Egon Tripodi (Hertie) C7 Fall 2024 12 / 37  Taxation When statutory equivalence does not hold We focus on cases where statutory equivalence holds, but this is not always true Market structure matters Cases where statutory equivalence may not hold: 1 In markets with a few dominant sellers (oligopoly): Sellers may collude to raise prices, making buyers bear more of the tax. Conversely, if sellers are competing intensely on price, they might lower their