Economics PDF

CAPITOLO 1: what is economics? what is capitalism? What is economics about? XXth century: Max Weber: economic actions: actions that relate to the satisfaction of a desire of utility Lionel Robbins: the science of decisions over the scare resources Economics as a social science: Focuses on social phenomena Aims at generating cumulative knowledge through rigorous procedures and generalizable findings It focuses on the material welfare of human populations Economics: multiple theories, multiple approaches, multiple epistemological choices: holism or individualism + methods: love for models: simplified representations of a real situation that are used to better understand real life situations + ceteris paribus: all but the key variables are allowed to change + hypothesis testing: key empirical strategy Hypothesis: a statement about casual relationships that is to be tested Assumption: a statement about casual relationships that is not to be tested Axiom: is a fundamental belief held by a scientist that condition his/her causal explanation. RCT = Randomized Clinical Trials Variety of models: ➔ TYPE A: models that look at the functioning of the system ➔ TYPE B: models that look at the individual behaviour TYPE A: circular flow diagram: PROPERTIES: -Trade -> barter: people directly exchange goods and services that they have for what they want -Firms sell goods and services that they produce to households in markets for goods and services. Firms buy the resources they need to produce goods and services in Factor Markets -An economy’s INCOME DISTRIBUTION is the way in which total income is divided among the owners of the various factors of production TYPE B: mainstream economics: Individual behavior as CHOICE a) The use of scarce resources b) To reach a certain goal (well-being / utility). -Choice parameters: 1. Opportunity cost: foregone benefits of an option non taken 2. Trade-off: choice between 2 or more options entail payout gains and losses. Choice between payoffs The relationship of economics with data PRODUCTION POSSIBILITIES FRONTIER (PPF) PPF is a diagram that shows the combinations of two goods/services that are possible for a country/ firm to produce at full employment of the firm’s resources. “possibility”= results from the availability of finite resources ➔ We can use the PPF model to answer questions like: How much can we produce? What will it cost us to change our mix of production? Does it make sense to import the good from somewhere else? ➔ Y = a+bX a is the interception between the line and the y axis b is the Opportunity cost: the slope of the line opportunity cost increases along the PPF, why? resources are not equally usable for all goods ➔ Economic growth (outward shift of PPF): outcome of increased productivity (productive efficiency) and allocative efficiency over time + prices (relative prices) play an important role GROSS DOMESTIC PRODUCT (GDP): overall value of final goods and services produced within a country in a year ➔ Absolute poverty: who lives below the poverty line ➔ Poverty line: the monetary value of goods and services essential to each family ➔ Wealth distribution: Hockey stick graph: divide GDP by the total population, and use the resulting number—GDP per capita—to measure average income, or ‘living standards’. ➔ rapid economic growth -> capitalism ➔ CAPITALISM: an economic system based on capital accumulation. It is the mechanism through which capital at time t becomes a larger sum of capital at time t+1 ➔ 3 PILLARS OF CAPITALISM: 1. private ownership of means of production 2. the business firm is the prevailing form for organizing production 3. the market is the prevailing institution for the allocation of resources CAPITOLO 2: How can we understand the economic foundations of our world? o INDUSTRIAL REVOLUTION: reasons for English take-off: 1. a technical- scientific revolution, more advanced in England 2. abundance of coal 3. ability to use military means to ensure access to input-output markets 4. political structure and institutions that are more favourable to economic development 5. a culture conductive to capitalism 6. casual several factors Alternative theories (critical): 1. Karl Marx in the ‘Capital’: criticizes capitalism, massive exploitation of peasants 2. Colonialism and slavery o PRODUCTION FUNCTION (analytical tool for economists): relation between the quantity of a good or service that is produced and the means used to produce such good or service generic form= Y=f(X) o INPUT-OUTPUT MODEL: the basic model used to describe the production process: ➔ “Output” is the quantity produced of a good or service ➔ “Input” factors of production used to produce that good or service MAIN inputs: 1. LABOUR: the effort produced by workers (L) 2. CAPITAL: all other factors of production (K) The function becomes: Y=f(K,L) PRODUCTION TECHNOLOGY: particular combination of inputs used to produce an output (firms, managers,..) Choice of production technology: (criteria) 1. quantity produced (output) 2. cost of production When is technology efficient (PRODUCTIVE EFFICIENCY)? Given the resources, one obtains best result (highest output). Given the result (output level), one uses the least quantity of resources. A solution that results in less efficient technology is called “dominated technology” with respect to another. If the goal is maximum profit: PROFITS = REVENUES – COSTS PRODUCTION COSTS: relative prices of the factors of production (inputs) -Total cost of output = sum of all input costs -Input cost = input unicast * quantity of input used o ISOCOST: a line that comprises all the production technologies with the same total cost The equation of a line with 2 variables: K (capital), L (labour) and two constants c/r, -w/r ➔ -w/r, is the slope coefficient of the isocost, that is, the relative price of labour and capital. ➔ The minus in front of the slope is the trade-off between K and L: in order to keep total production costs constant, the increase in the quantity of one input must be compensated by a decrease in the quantity of the other input (if w/r varies, the slope changes) ➔ If there are changes in relative prices and technology becomes more convenient: Innovation rent ➔ A decrease in the amount of labor necessary to produce a given quantity of output: Labor saving o MALTHUSIAN TRAPS: To understand Malthus’ model, we need to use the concept of productivity. PRODUCTIVITY: average productivity of an input indicates how much output (on average) can one unit of input produce AVERAGE PRODUCTIVITY = ➔ Malthusian hypothesis: decreasing average productivity of labour ➔ Second hypothesis: as living standards improve, population grows ➔ =Technological progress cannot lead to a permanent improvement in a population’s living standards. CAPITOLO 3: Foundations of neoclassical microeconomics: the market, part 1a Comparative advantage and the gains from trade FROM PRODUCTION TO EXCHANGE: we can use the PPF to visualize the gains from trade in terms of allocative efficiency. Trade may enable a more efficient allocation of resources ➔ This is the THEORY OF ABSOLUTE AND COMPARATIVE ADVANTAGE carried by classical political economy. 1. BASES OF ABSOLUTE ADVANTAGE: according to the theory of absolute advantage trade is a positive sum game for nations (it generates mutual gains for participants) Such mutual gains emerge from the participants’ SPECIALIZATION in the production of the good/service where they have an ABSOLUTE ADVANTAGE (when a country is more efficient in the production of one given good or service) Trade benefits both participants if both hold absolute advantages (in the production of different goods). What happens when this is not the case? (when one country/ participant is more efficient than the other in all sectors) In this case, according to David Ricardo, trade is still mutually beneficial -> Comparative advantage theory. 2. LAW OF COMPARATIVE ADVANTAGE: even if one county holds absolutely disadvantages in the production of all goods, it will still benefit from trade. The country with absolute advantage will specialize in the production of those goods where the productivity gap/ absolute advantage is higher The county with absolute disadvantage will specialize in the production of those goods where the productivity gap is lower ➔ If a county holds the same absolute advantage in all sectors of production then the productivity gap is the same in all goods -> there are no mutual gains or comparative advantages ➔ The existence of mutual gains from trade depends on the ratio of productivity differentials and monetary wage differentials Ricardo’s comparative advantage theory relies on a series of assumptions: 1. Only 2 countries and 2 goods are considered 2. Trade is free 3. Labour mobility is perfect within one country but non-existent in between countries 4. Production costs are constant 5. No transportation costs 6. No technological progress 7. Economic value originates from labour ➔ The labour theory of value presents 2 major problems for explaining the existence of comparative advantage: 1. such theory implies either that labour be the sole factor of production, or that labour is used in fixed proportions in the production of all goods and services 2. such theory implies that labour is homogeneous Both hypothesis are false: to explain the existence of comparative advantages: OPPORTUNITY COSTS OPPORTUNITY COST of a good: the quantity of another good that must be sacrificed so as to release the resources necessary for the production of a unit of the good. (A county has a comparative advantage in producing a good or service if its opportunity cost of producing that good or service is lower than other countries) ➔ In AUTARCHY, every time a county consumes what it produces: its PPF = CPF (consumption possibility frontier) (With international trade, each country can consume higher quantities of both goods) CAPITOLO 4: Foundations of neoclassical microeconomics: the market, part 2. Demand, supply and market equilibrium o WHAT IS A MARKET? possible definitions: ➔ A place (physical or virtual) where economic exchange takes place ➔ A mechanism for allocating resources (alternative to the state or business firms) ➔ An institution (which sets rules and settle distributional conflicts) o To classical and, even more, neoclassical economists, markets are the central institution of modern capitalism. o In particular, correctly functioning markets are instrumental to: ) An efficient allocation of resources within the economy; (Markets are seen (by neoclassical economics) as the most efficient system of allocation) ) Long-term economic growth; (Tight relationship between market exchange and productive and allocative efficiency) o Problems with the traditional, neoclassical view:. Markets often (if not always) do not function in the “correct” way.. Markets are embedded in social relationships; (In particular, financial markets are, historically, creatures of the state). Markets are not always (often?) the most efficient system of allocation. (Market failure theory: governments have to step in). The neoclassical view focuses on commodities markets; but there are plenty of markets that do not work in this way. o Matching vs. commodity markets: On commodity markets, price is the sole determinant of resource allocation who gets what. There are numerous markets, however, where price is not the sole determinant of who gets what. Just like in various markets where price is not even allowed to determine resource allocation (these are called matching markets). o A further problem: the commodification of social and economic life Thirty or forty years ago, in most countries, markets were not as important as today. Key resources (water, electricity, education...) were allocated through non-market mechanisms, but 2 main things happened: Privatization (i.e. the shift of business ownership from state to private hands), Liberalization (i.e. the removal of barriers to entry and exit in markets), because of structural changes of modern capitalism. Consequence: many goods and services have been turned into commodities, allocation mostly determined by market prices. Why is that a bad thing? For two reasons, according to Sandel: (1) inequality and (2) corruption. o What do (commodities) markets do?. They enable transactions to take place.. They enable demand and supply to meet.. They enable the formation of prices. The formation of prices is a key function of markets and at the core of economic analysis. o A simple model: A first, simple market model considers the market as a place where demand and supply interact to form a price, such a market is assumed to be competitive. A competitive market has many buyers and sellers of the same good or service, none of whom can influence the price, the supply and demand model is a model of how a competitive market behaves. Demand: Demand represents the behaviour of buyers. A demand curve can be drawn up to show the quantity demanded at various prices, it is thus a relationship between quantity and price. {A change in price determines a change in quantity demanded along the demand curve: Downward (demand increases) if the price goes down; Upward (demand decreases) if the price goes up} (A rightward shift in the demand curve indicates an increase in demand that is not determined by a change in price but by exogenous factors) [When price alone changes, there is movement along a demand curve. When the demand shifts, people are buying more (or less) at ANY price] Many factors influence the quantity of a good or service demanded by the public (the buyers), besides price: 1. The buyer's monetary income; 2. The buyer's tastes (or preferences); 3. The buyer's expectations; 4. The price of another good or service. These all result in a lateral shift of the demand curve. The quantity demanded is the quantity that buyers are willing (and able) to purchase at a particular price. There is a negative relationship between price and quantity demanded: The higher the price, the lower the quantity demanded; The lower the price, the higher the quantity demanded. Because the higher the price, a) The less individual buyers are willing to acquire large quantities of that good; b) The lower the number of individual buyers are able to buy that good. The quantity demanded of a good and service can be influenced by the price of another good or service. Two particular cases: substitutes and complements. Two goods are substitutes if a decrease in the price of one leads to a decrease in demand for the other (or vice versa). ex. demand for online services when going to the shop becomes prohibited for health and safety reasons Two goods are complements if a decrease in the price of one good leads to an increase in the demand for the other (or vice versa). ex. Consumers often have to buy goods together. Changes in income: normal vs. inferior goods The effect of changes in income on demand depends on the nature of the good in question. A positive relationship between income and quantity demanded characterizes normal goods, where demand increases when income increases (and vice versa). A negative relationship between income and quantity demanded characterizes inferior goods, where demand decreases when income increases (and vice versa). Changes in tastes: According to the neoclassical view, tastes and preferences are subjective and vary among consumers. However, tastes are also socially determined, for example: demand for Halloween costumes in October. Other determinants of demand can be broadly categorized as “preferences”. Changes of expectations: If consumers have a choice about the timing of a purchase, they buy according to expectations. Buyers adjust current spending in anticipation of the direction of future prices in order to obtain the lowest possible price. Ex. if prices for the newest version of a trendy smartphone are expected to drop right before Christmas, what will happen to sales during November? The individual demand function: The relationship between the quantity demanded of a good or service and its various determinants is the object of the demand function. If a consumer can choose between n different goods, the quantity she'll demand (qdn) is a function of:. the price of the demanded good (pn);. income (I);. the prices of other goods (1 to n-1) (p1, p2, p3,..., pn-1);. the consumer's tastes and preferences (T);. the consumer's expectations (E). Thus we have: Changes in the number of consumers: Another important factor determining the quantity demanded of a good/service is the number of individual buyers, changes in the number of buyers depend on multiple factors, among which the other determinants of individual demand, such as changes in tastes. As a social network becomes more and more popular among young internet users, the demand for the related app will increase. Also, the number of suppliers is greatly affected by the institutions underpinning market structure. The market demand curve: The market demand curve is the horizontal sum of the individual demand curves of all consumers. The market demand function: we can conceptualize the relationship between the total quantity of a good that is demanded on a market, on the one hand, and its determinants, on the other. The total quantity of a good n demanded on the market (Qdn) is a function of: I. the price of the demanded good (Pn); II. buyers' average income (I); III. the prices of other goods (1 to n-1) (P1, P2, P3,..., Pn-1); IV. buyers' average tastes and preferences (T); V. buyers' average expectations (E); VI. the number of buyers on the market (B) ❖ Supply: Supply represents the behavior of sellers. The quantity supplied is the quantity that producers are willing and able to sell at a particular price. ❖ A supply curve shows the quantity supplied at various prices. There is a positive relationship between the price of a good and the quantity supplied of that good: - When the price increases, so does the supply of that good. - When the price decreases, so does the supply of that good. Because the higher the price, a) the higher the quantity of the good existing suppliers are willing to sell; b) the higher the number of suppliers. A change in price determines a change in quantity supplied along the supply curve: Downward (supply decreases) if the price goes down; Upward (supply increases) if the price goes up. A rightward shift in the supply curve indicates an increase in supply that is not determined by a change in price, but by exogenous factors. When price alone changes, there is movement along a supply curve. When the supply curve shifts, people are selling more (or less) at ANY price. Many factors influence the quantity of a good or service supplied by sellers, besides price: 1. Input prices; 2. Technology; 3. The buyer's expectations; 4. The price of related goods or services. These all result in a lateral shift to the curve Supply and changes in input prices: Inputs (or factors of production) are necessary for any production to take place, the quantity of output (the amount of goods and services supplied by sellers on the market for goods and services) depends in large part on the quantity of inputs. In the choice of factors of production, producers (sellers on the market for finished goods and services) must take their cost into consideration, the cost of factors of production is = price * quantity. Output (supply) is thus determined in part by input prices. A decrease in the price of an input (all else equal) decreases production cost and therefore encourages more supply (and vice versa). Supply and changes in technology: Like input prices, technology is an important factor in determining output. Changes in technology affect production costs, and thus affect production choices. New, better technology enables sellers (producers) to produce a higher quantity of output at a given cost or to produce the same quantity of output at the same cost. Thus, technological progress makes sellers willing to offer more at a given price or sell their quantity at a lower price. – A technological innovation lowers costs and increases supply. Supply and changes in expectations Expectations do not influence buyers only, sellers will be affected by, in part, expectations about present and future sales, future prices, future input prices. The expectation of a higher price for a good in the future decreases current supply of the good – if they can store the good (and vice versa). Sellers will adjust their current offerings in anticipation of the direction of future prices in order to obtain the highest possible price Supply and changes in the prices of related goods and services: We need to distinguish here between: Complementary production goods: those goods that are produced together with other goods (such as gasoline and oil); Substitutive production goods: those goods that can be produced in alternative with other goods, using the same inputs (such as wheat and corn). The effect of changes in the price of relative goods and services will thus differ: In the case of complementary goods, the increase in the price of one good will lead to an increase in the supply of the other good; In the case of substitutive goods, the increase in the price of one good will lead to a decrease in the supply of the other good. ❖ The individual supply function: The relationship between the quantity supplied of a good or service and its various determinants is the object of the individual supply function. If an individual supplier can choose between the production of n different goods, the quantity she'll supply to the market (qsn) is a function: i. of the price of the supplied good (pn); ii. of input prices (PI); iii. of the prices of other goods (1 to n-1) (p1, p2, p3,..., pn-1); iv. of technology (Te); v. of the supplier's expectations (E). Changes in the number of suppliers: Another important factor determining the quantity supplied of a good/service is the number of individual sellers, this number depends on numerous factors, among which the determinants of individual supply.– For instance, technological progress may enlarge the potential range of suppliers. Also, the number of suppliers is greatly affected by the institutions underpinning market structure.– For instance, the creation of a modern public debt market in late XVIIth century England led to an increased number of sellers of financial products. Changes in the number of supplier are called market entry and market exit: – Entry implies more sellers in the market, increasing supply;– Exit implies fewer sellers in the market, decreasing supply. ❖ The market supply curve is the horizontal sum of the individual supply curves of all producers. ❖ The market supply function: we can conceptualize the relationship between the total quantity of a good that is supplied on a market and its determinants. The total quantity of a good n supplied on the market (Qsn) is a function:. of the price of the supplied good (Pn);. of the price of inputs (PI);. of the prices of other goods (1 to n-1) (P1, P2, P3,..., Pn-1);. of technology (Te);. of sellers' average expectations (E);. of the number of sellers on the market (S) Demand, supply and market equilibrium Markets are instances of coordination between demand and supply. Coordination succeeds if the quantity demanded and the quantity supplied of a good/service are equal. When Qs = Qd at a certain price, the market is said to be in equilibrium (the amount consumers would purchase at this price is matched exactly by the amount producers wish to sell). An equilibrium is a stable situation towards which market forces endogenously tend, the key coordinating mechanism, here, is the price of the good/service. The price at which this takes place is the equilibrium price, also referred to as the market- clearing price. The quantity of the good or service bought and sold at that price is the equilibrium quantity. A market does not have to be in equilibrium at all times. Neoclassical economists concede that disequilibria can exist, however, in well-functioning, competitive markets such disequilibria are temporary because the price varies to help buyers and sellers reach an “agreement” - so as to make the quantity demanded and the quantity supplied equal again. There are two kinds of disequilibria: surpluses and shortages. When the market price of a good is higher than the equilibrium price, supply exceeds demand. There is a surplus, an excess of supply over demand. In a well-functioning market, a surplus will push the price down until it reaches the equilibrium price. There is a shortage when the quantity demanded exceeds the quantity supplied, shortages occur when the price is below its equilibrium level. This shortage will push the price up What happens when the demand curve shifts? An increase in demand leads to a movement along the supply curve to a higher equilibrium price and higher equilibrium quantity. What happens when the supply curve shifts? An increase in supply leads to a movement along the demand curve to a lower equilibrium price and higher equilibrium quantity. Simultaneous shifts of the demand and supply curves: a) If the decrease in demand is relatively larger than the increase in supply, the equilibrium price and quantity falls. b) If the increase in supply is large relative to the decrease in demand, the equilibrium quantity rises as the equilibrium price falls. CAPITOLO 5: Foundations of neoclassical microeconomics: the market, part 3. Elasticity The concept of elasticity: We know how the quantity demanded of a good or service changes when the price of that good/service changes. But how much does quantity demanded change when price changes? Or more generally, how do demand/supply change when one of their determinants (price, income...) changes? Elasticity is the measure of the sensibility of the demand / supply of a good to changes in price / income. o Price elasticity of demand: (remember that there is a negative relationship between the price of one good/service and the quantity demanded of that good/service) A demand is elastic to prices when an increase in price reduces the quantity demanded a lot (and vice versa). When the same increase in price reduces quantity demanded just a little, then demand is inelastic. The more responsive/sensitive quantity demanded is to a change in price, the more elastic is demand to price. o Elasticity and the demand curve: Elasticity ≠ slope, but: If two linear demand (or supply) curves run through a common point, then at any given quantity, the curve that is FLATTER is MORE ELASTIC. o Measuring elasticity: Price elasticity of demand = the percentage change in quantity demanded divided by the percentage change in price. The elasticity coefficient is always positive. Since we know that price and quantity demanded will always move in opposite directions (law of demand) we usually drop the minus sign (for price elasticity of demand ONLY). There is a problem: Our percent change calculation depends on our choice of starting point. To solve this problem, we may calculate the price elasticity of demand using the midpoint formula for percentage changes: instead of dividing by the initial quantity or price, we’ll use the average quantity or price. o Interpreting the price elasticity of demand: Demand for a good or service can have a price elasticity as low as zero or as high as infinity, it follows that: i. If the elasticity coefficient is below 1 (Ed < 1), demand is inelastic. ii. If the elasticity coefficient is above 1 (Ed > 1), demand is elastic. iii. If the elasticity coefficient equals 1 (Ed = 1), demand is unit elastic. o The determinants of price elasticity of demand: The availability of close substitutes is very important. -> Fewer substitutes makes it harder for consumers to adjust Q when P changes, so demand is inelastic. While if there are many substitutes, switching brands when prices change is EASY, so demand is elastic. Whether the good is a necessity or a luxury also affects the elasticity of demand. -> For necessities, we do not change Q much when P changes. While for luxuries, we are more sensitive to P changes. The share of income spent on the good matters. -> We are less sensitive to price changes when the good feels cheap. We are more sensitive to price changes when the good feels expensive. Time elapsed since the price change matters. -> Less time to adjust means lower elasticity, over time consumers can adjust their behaviour by finding substitutes (making demand more elastic). o Other demand elasticities: cross-price elasticity of demand: The cross-price elasticity of demand measures how sensitive the quantity demanded of good A is to the price of good B. o Cross-price elasticity of demand for substitutes and complements: For substitutes, cross-price elasticity of demand is positive. (ex. An increase in the price of one brand of cookies will increase the demand for other brands) For complements, cross-price elasticity of demand is negative. (ex. An increase in the price of tea causes a decrease in demand for biscuits). o Income elasticity of demand: The income elasticity of demand measures how sensitive the quantity demanded of a good is to changes in income. Income elasticity of demand for normal and inferior goods: The income elasticity of demand can be used to distinguish normal from inferior goods. For normal goods, income elasticity is positive. For inferior goods, income elasticity is negative. Normal goods can be income-elastic or not. For income-elastic goods, income elasticity is greater than 1 For income-inelastic goods, income elasticity is positive but less than 1. Elasticity of supply: Elasticity of supply captures the sensitivity of quantity supplied to changes in price. Supply curve is elastic if a rise in price increases the quantity supplied a lot (and vice versa). It’s inelastic if sellers change quantity just a little. Price elasticity of supply: Usually, sellers offer more when prices are higher, but how strong is that relationship? Similar to price elasticity of demand. Two extreme cases of price elasticity of supply Determinants of the price elasticity of supply: Availability of inputs. -> If increased production is very expensive, then the supply curve will be inelastic. If production can be increased cheaply, then the supply curve will be elastic. Time. -> Price elasticity of supply increases as producers have more time to respond to price changes. Long-run price elasticity of supply is usually higher than the short-run elasticity CAPITOLO 5: Foundations of neoclassical microeconomics: the market, part 3.1 Evaluating markets: efficiency and equity Bases for market evaluation: As systems of allocation, markets can be assessed or evaluated on the basis of two parameters: allocative efficiency and equity ➔ Allocative efficiency concerns the adequacy of resource allocation to resource availability and needs (or desires). A system of allocation (a market, for instance) will be efficient if it allocates resources adequately, consequently there will be no shortage or surplus. ➔ Equity concerns the fairness of resource allocation, but there are various definitions: Each one should receive according to his/her needs and contribute according to his/her capacities. The allocation of resources to the highest-earners should not be more than X time the allocation of resources to the lowest-earners. Pareto efficiency: Pareto efficiency can be assessed by comparing the payoffs of economic agents in an economic transaction. ➔ A Pareto-efficient allocation is an allocation of resources/goods such that it is not possible to improve anyone's welfare without worsening the welfare of anyone else. ➔ A Pareto-dominated allocation is an allocation of resources such that it is possible to improve someone's well-being without changing the well-being of others. Measuring market efficiency: consumer and producer surplus: One standard measure of markets' allocative efficiency is the calculation of the so-called consumer surplus and producer surplus. ➔ Consumer surplus: the difference between market price and what consumers (as individuals or the market) would be willing to pay. (A consumer’s willingness to pay for a good is the maximum price at which he or she would buy that good) Consumer surplus rises with a decrease in prices. ➔ Producer surplus: the difference between market price and the price at which firms are willing to supply the product. Producer surplus rises if the price increases o Individual producer surplus is the net gain to an individual seller from selling a good. It is equal to the difference between the price received and the seller’s cost. o Total producer surplus is the sum of the individual producer surpluses of all the sellers of a good in a market. ➔ Total surplus: the sum of the producer and consumer surpluses If total surplus is maximized with competitive markets, then the latter are efficient. Three ways you might (unsuccessfully) try to increase the total surplus: 1) reallocate consumption among consumers; Why? Every student who buys a book at the market equilibrium has a willingness to pay of $30 or more, and every student who doesn’t buy a book has a willingness to pay of less than $30. 2) reallocate sales among sellers; Why? Any student who sells a book at the market equilibrium has a lower cost than any student who keeps a book. 3) change the quantity traded. Why? Anyone who wouldn’t have bought the book has a willingness to pay of less than $30, and anyone who wouldn’t have sold has a cost of more than $30. Market efficiency: Within neoclassical economics, competitive markets are seen as efficient because: 1. They allocate consumption of the good to the potential buyers who most value it. 2. They allocate sales to the potential sellers who most value the right to sell the good (e.g., who have the lowest cost). 3. They ensure that all transactions are mutually beneficial: Every consumer who makes a purchase values the good more than every seller who makes a sale. CAPITOLO 6: Foundations of individual behaviour. From homo economicus to homo sapiens to the social animal Neoclassical economics, which still dominates the “mainstream”, was conceived as the “science of choice”, decision-making was seen as the key object of inquiry. In particular, individual decision- making. Methodological individualism: the decision to explain social (economic) phenomena with individual behaviour. Here classical and neoclassical economics differ from other branches of economics and social sciences, in particular, contrast with methodological holism. Decision-making processes were conceived by neoclassical economics (heirs of classical political economy) as having 2 key characteristics:. The end / goal of such processes is the satisfaction of self-interest Individual interest famously guides economic agents in a capitalistic economy Self-interest is not a synonym to selfishness: “How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him.” Adam Smith;. Processes are dominated by rationality. The economic decisions of individuals, according to neoclassical (and classical) economists, are rational, they involve a conscious weighing of the end, the means and secondary results of the decision. Neoclassical economists have preferred to self-interest (too vague and multidimensional) the concept of utility: the degree of individual satisfaction derived from a given action, decision, or allocation of resources. In the 1860s and 1870s, “marginalist” economists broke with classical political economy on two grounds: First, they desired to make economics more “rigorous” by importing methods and notions from mechanical physics; Secondly, they led a shift to a monodimensional determination of individual behaviour based on subjective ends. Why such shift? From Classical political economy's focus on economics of production, with its objective determinants - secondary role given to the market of finished goods and services in absorbing production to focus on the Consumer. Critics of homo economicus: Marx; Marx and Marxian political economy: first (historically) comprehensive critique of classical political economy. Karl Marx (1818-1883) criticized, in particular, the “fictions without imagination of the XVIIIth century Robinsonades.”, i.e. the myth of an atomistic individual as representative of the economic agent in itself. Underscoring how the epoch that develops this individualistic vision is also the times were men are more engaged in social relationships than ever. In addition, it does not make sense to construct a homo economicus out of the consumer, consumption and production are intertwined. Critics of homo economicus: the Marxists Nikolaj Bucharin (1888-1938)'s critique of the marginalist school. “Political economy of the rentier.” (1914): “The concept of utility does not suppose any 'work effort', nor production; it expresses not an active, but a purely passive relationship with things.” Instead, the consumer is a social agent, whose consumption reflects a state of necessity that of selling his/her labor force on the market to sustain his/herself. Rudolf Hilferding (1877-1941)'s critique of the Austrian school's subjective conception of value. Commodities are valued not because of their usefulness, but because they can be exchanged on the market. Since the mid-XXth century, behavioural sciences (psychology, economics) have developed a vast research program investigating deviations from the perfect rationality embodied by homo economicus. This heterogenous program has developed along multiple distinct paths: ➔ Game theory; ➔ Behavioural economics:. Experimental economics;. Prospect theory;. Nudge. Although all interested in studying deviations from perfect rationality, these approaches are not radically at odds with the premises of neoclassical economics. GAME THEORY: In the 1940s, John von Neumann (1903-1957) and Oskar Morgenstern (1902 1977) laid the foundations of game theory (GT). GT aims understanding individual decision-making in conditions of strategic interactions (games). A game is a situation where the participants’ payoffs depend not only on their decisions, but also on their rivals’ decisions. There are many games. All have the following properties: ➔ It is played simultaneously by 2 or more agents; ➔ Each agent behaves rationally, i.e. in a way that maximizes his/her payoff; ➔ Each agent's actions (decisions) have an impact on the other agent's payoff prospects (strategies); ➔ Each agent is aware of such strategic interactions and incorporates those in his/her decision- making process The characteristics of games economic agents play Four defining characteristics:. The number of players;. The rules of the game;. The outcomes of each move;. The payoffs associated with each outcome. Two broad families of games: ▪ Simultaneous games; (Players make their moves simultaneously - ex. the Prisoners' Dilemma). ▪ Sequential games. (Players make their moves in a sequence - ex. the Ultimatum game). The prisoners’ dilemma: two suspects are arrested on the same charge, they are interrogated simultaneously and separately. each prisoner has 2 options: to confess committing the crime or to plead innocent. The payoff consequent to the decision is the length of the prison sentence, trying to minimize it. One player’s payoff depends on the interaction between his action and the other player’s (if player 1 confesses and player 2 does not, player 2 will receive a heavy sentence and player 1 a light one). What is the decision to make? example: Dominant strategies: A dominant strategy is a strategy that results in the highest payoff to a player regardless of the opponent’s action, however not all games have dominant strategies. In our case Louise's dominant strategy is to confess, Thelma's dominant strategy is to confess. Both dominant strategies concur to a Nash equilibrium. Nash equilibrium: a situation in which no player can improve her payoff by unilaterally changing her own strategy, given the other player’s strategy. (every player is doing the best they possibly can, given the other player’s strategy) Note: in the previous example, both players would have been better off had they decided both to not confess. However, no player knew for sure how the other would behave, this uncertainty implied a higher risk for the “do not confess” strategy - a higher potential loss (10 years in jail). If both agents are risk-adverse it is rational for both players to choose to confess. Rationality, limited rationality and irrationality in economics: Narrowly defined rationality does not dominate all the choices of economic agents, all the time, sometimes it can be rational to choose a worse payoff for oneself: ➔ Concerns about fairness: Providing for others sometimes trumps self-interest. ➔ Bounded rationality—“good enough”: Making a choice that is close to (but not exactly) the highest possible profit MAY MAKE SENSE because the effort of finding the best payoff is too costly. ➔ Risk aversion: Willingness to sacrifice some economic payoff in order to avoid a potential loss is fairly common. Some other times / in other contexts, agents can act irrationally: the agent chooses a course of action that leaves him/her worse off, while not consciously aiming for that payoff. Uncertainty and animal spirits: ➔ To John Maynard Keynes (1883-1946), uncertainty was the defining characteristic of economic agents' environment: Decision-making in an uncertain world diverges radically from decision making in a certain world. ➔ “Animal spirits”: drivers of decision-making that are NOT derived from a careful calculation of costs and benefits, but from confidence, concern about fairness - Resentment against unfairness. ULTIMATUM GAME: A sequential game where 2 players bargain (anonymously) to divide a fixed amount between them. Firstly, player 1 or “the proposer” offers a division of the amount, then player 2 or “the responder” decides whether to accept the proposer’s offer. If accepted, both players get their agreed shares, if rejected neither player receives anything. Predictions: There is a Nash equilibrium as long as the responder accepts anything from the proposer, as long as he/she is better off than receiving nothing. 3 Nash equilibria: ➔ The proposer makes a fair offer; the responder would accept any fair offer. ➔ The proposer makes an unfair offer; the responder would accept any unfair offer. ➔ The proposer makes an unfair offer; the responder would accept any offer. Prospect theory: First developed by Daniel Kahneman (1934-) and Amos Tversky (1937-1996). Builds on experimental economics to explore the heuristics and biases of individual agents. Explains the causal factors behind the cognitive errors made by economic agents: ➔ Risk aversion; ➔ Loss aversion; ➔ Preference for the status quo; ➔ Endowment effect. Nudge: Richard Thaler (1945-) and Cass Sunstein (1954-). The economic agent is a cognitively defective agent: Not homo economicus, homo sapiens. Thus a “choice architect” must design the agents' “choice menu” to guide him/her towards the decision conducive to his/her well being. A nudge is “any aspect of the choice architecture that alters people's behaviour in a predictable way without forbidding any options or significantly changing their economic incentives. To count as a mere nudge, the intervention must be easy and cheap to avoid. Nudges are not mandates. Putting fruit at eye level counts as a nudge. Banning junk food does not.” A few heuristics: Loss aversion: Key finding of prospect theory. Agents tend to accept losses less than they accept gains. The pain of losing X is higher than the pleasure of gaining X. Law of small numbers: Intuition against statistics. We tend to value inferences in the same way, regardless of the size of the sample our inference is based on. But extreme outcomes (both high and low) are more likely to be found in small than in large samples. (The law of small numbers is the name economists give to a very common mistake people make when it comes to making predictions or gauging probability. The simplest example of it is when we toss a coin. Every time we toss a coin there is a 50% chance that it will land on a head and a 50% chance it will land on a tail. However, if we get a run of, say, five straight heads, we might start to feel as if the next time we toss the coin there will be a higher probability of it being a tail. This would be wrong because the outcome of each toss of the coin has no bearing on the next one, so the odds of each toss are still 50/50. The reason we make this mistake, according to behavioural economists, is that humans tend to put too much faith in small amounts of information. In some situations, this approach might be valid. For example, if you have 10 red balls and 10 black balls in a bag and randomly pick five consecutive red ones without replacing them, the odds of drawing a black one next will increase. But in the case of tossing a coin, each outcome is completely independent of what came before and what will come after. Every time you have an equal chance of getting a head as you do of getting a tail.) Representativeness: Tendency to use partial information to judge probability. Drives us to ignore facts that go against our intuition. Excessive willingness to predict the occurrence of unlikely events. Ex: a NYT reader in the subway (Kahneman). Is he/she more likely to be a librarian or an service worker? Your mind automatically “jumps off to conclusion”, associating NYT reading with intellectual work (librarians). But librarians are much rarer than service workers... Endowment effect: Agents are more likely to retain an object they own than acquire it when they do not own it. (Linked to loss aversion). [The endowment effect refers to an emotional bias that causes individuals to value an owned object higher, often irrationally, than its market value]. Optimism / wishful thinking: Agents' belief in a successful outcome is based on optimism, not on a rational calculation. Ex. All players believe in their chances of winning. Overconfidence: When economic agents believe that they are better forecasters than they really are. Ex.: sports, the stock market Framing: Economic agents are influenced in their choices / decisions by the ways in which such choices / decisions were presented to them. Example: phrasing of a referendum question / a menu. Contrast “Are you for or against the death penalty?” with “are you for or against the right to terminate a bloodthirsty killer's life?” Anchoring: The process of planting a thought in a person's mind that will later influence this person's actions. Hot hand fallacy: The belief that a person who experiences success with a random event has greater probability of further success in future attempts. Self-handicapping: A cognitive strategy where agents avoid efforts to prevent damage to their self- esteem. Creating obstacles to manage future explanations for their failure. Example: not preparing for an exam... Gambler's conceit: An erroneous belief that someone can stop a risky action while still engaging in it. The gambler continues to engage in a risky behaviour even as this is against his/her best interest. CAPITOLO 7: A neoclassical model of consumer behaviour: Preferences, budget constraint, utility maximization Individual consumer behaviour: the core of neoclassical economics -> The neoclassical economic revolution largely revolved around new approaches to explain economic agents' behaviour. Behaviour reduced to rational decision-making. How do rational consumers choose what to spend their money on? As seen in lecture 6, neoclassical economics re-framed self-interest as utility. Utility can be defined as the degree of satisfaction or well-being deriving from the consumption of a given good or service. Such utility is pure subjective: it varies from one consumer to the next. The degree of utility obtained from the consumption of one good or service increases as the quantity consumed that good or service increases. Until the saturation point. We can define the utility function of a consumer of good A as the (positive) relationship between the quantity consumed of good A and the degree of utility derived from such consumption: Total and marginal utility: ➔ Total utility: Increases until saturation point. ➔ Marginal utility: The utility deriving from one additional unit of good A consumed. Marginal utility decreases as the quantity of a good that is consumed increases. Becomes equal to zero at saturation point and becomes negative beyond that point. This characteristic has been elevated to a “law” by neoclassical economics: the “law of diminishing marginal returns” The economist posits that each consumer holds preferences about the bundle of goods and services he/she wishes to consume. -> His job consists in ordering these preferences so as to determine the choice of each individual's consumption set. The main way of ordering preferences is given by indifference curves. Indifference curve graphically represent all the combinations of two goods/services (or two baskets of goods and services) that give the same level of utility to the consumer. Three axioms: 1. Non satiety. If we consider two baskets, A and B, that have the same quantities of the first n-1 goods, but basket A has a major quantity of the nth good, then A is preferred to B (A & B do not belong to the same indifference curve). 2. Completion. The consumer is always able to choose between different combinations or baskets. She knows whether A>B (A preferred to B), if B>A or if A=B. 3. Transitivity. if A>B and B>C then A>C. The further away is an indifference curve from the origin, the higher the utility. A map of indifference curves is the ensemble of indifference curves that represent the preferences of one consumer towards all the possible combinations/baskets of two goods/services. The marginal rate of substitution: The marginal rate of substitution (MRS) represents the quantity of a good or service that a consumer is willing to sacrifice to consume one additional unit of another good or service, keeping her utility unaltered. It corresponds to the slope of indifference curves -> Properties of the MRS: ➔ Along an indifference curve, the MRS decreases Why? Because marginal utility decreases. →As the quantity of a good that is consumed increases, the utility associated with the consumption of additional units of that good decreases. This explains why indifference curves are convex with respect to the point of origin. Extreme cases: substitutes and complements: ➔ Two goods or services are perfect substitutes when the utility derived from the consumption of one good or service is identical to the utility derived from the other good or service. The MRS is constant along the indifference curve (the indifference curve will be of the type: y= -x) ➔ Two goods or services are perfect complements when the utility derived from the consumption of one good or service depends on the quantity consumed of the other good or service. (the indifference curve will be L shaped with a sharp angle). Ordering the consumer's preferences is not enough to determine his/her choice. Obviously, given the model's assumptions, any consumer will desire that bundle of goods and services that gives him/her the maximum utility. However, the consumer's choices are constrained by his/her resources (are subject to constraint). The budget constraint: Because the amount of money a consumer can spend is limited, a decision to consume more of one good is also a decision to consume less of some other good. A budget constraint requires that the cost of a consumer’s consumption bundle be no more than the consumer’s income. A consumer’s consumption possibilities is the set of all consumption bundles that can be consumed given the consumer’s income and prevailing prices. A consumer’s budget line shows the consumption bundles available to a consumer who spends all of his or her income. The budget constraint indicates all the amounts of goods and services that can be acquired by the consumer, given (a) the consumer's income and (b) the prices of the goods and services. Budget constraint formula: The budget line indicates all the amounts of goods and services that can be acquired by the consumer if the consumer spends his/her entire income. Budget line formula: From this, the slope is: -Pb/Pa; It is a straight line, downward sloped because for the consumer to be able to consume one more unit of one good, he/she has to give up x units of the other good. When the consumer substitutes one (affordable) bundle of goods with another, one moves along the budget line. There will be a shift of the budget line when: The consumer's income increases or decreases; The price of good A increases or decreases; The price of good B increases or decreases; Predicting the consumer's choice: Predicting the consumer's choice is equivalent to solving a simple problem of maximization subject to a constraint. Here, it is assumed that the consumer will seek to maximize his/her utility, given his/her budget constraint. The bundle of goods/services that corresponds to the solution to that problem is called the consumer's optimal choice. We can solve this puzzle graphically, by combining indifference curves and the budget line. The optimal choice: The consumer's optimal choice corresponds to the bundle of goods and services that is located on the budget line and belongs to the indifference curve that is further away from the point of origin. That bundle is also the point of tangency between the budget line and the indifference curve. The consumer's optimal choice or bundle of goods/services will be that bundle that equates the two coefficients, that is, whether the following condition holds: Thus, the optimal choice also corresponds to the point where: UmF/PF=UmC/PC This corresponds to the principle of marginal equalization: The consumer's total utility is maximized when the marginal utility per unit of money spent is equal for each good. The income-consumption curve: The shape of the income-consumption curve depends on two factors: 1. The individual consumer's preferences and hence the shape of the consumer's indifference curves. 2. The “subjective nature” of the goods When the income-consumption curve is positively sloped, the quantity of a good that is demanded by the consumer increases with income: The good is a normal good. When the income-consumption curve is negatively sloped, the quantity of a good that is demanded by the consumer decreases when income increases: The good is an inferior good. The Engel curve: The Engel curve is the graphic representation of the relationship between a consumer's income and the quantity of a good that is demanded by such consumer. If the Engel curve is positively sloped, demand increases with income: we are dealing with a normal good. (y=x) If the Engel curve is negatively sloped, demand decreases when income increases: we are dealing with an inferior good. The price-consumption curve is composed of the optimal bundles of two goods/services corresponding to various prices of one of these goods. Let's transpose the values of PF and the corresponding values of the consumer's optimal consumption choice on a new graph. On the vertical axis we transpose the various prices of good F, while on the horizontal axis we transpose the various quantities of good F that correspond to the consumer's optimal choice for each price of F. We obtain the individual consumer's demand curve. The individual demand curve represents, for any given income and given the prices of other goods and services, the optimal quantity demanded by a consumer for each level of price. Indicates a negative relationship between price and quantity demanded. Its slope depends on the sensitiveness of individual demand to changes in prices. The optimal consumption rule explains why we buy less of something when its price rises (and vice versa). The substitution effect (of a change in the price of a good) is the change in the quantity consumed of that good as the consumer substitutes the good that has become relatively cheaper for the good that has become relatively more expensive. The income effect (of a change in the price of a good) is the change in the quantity consumed of a good that results from a change in the consumer’s purchasing power due to the change in the price of the good. ➔ Normal goods: Increase in price causes consumers’ purchasing power to drop and reduces consumption (and vice versa). ➔ Inferior goods: Increase in price causes consumers’ purchasing power to drop and increases consumption (and vice versa). Giffen good: a very rare inferior good for which the income effect outweighs the substitution effect and the demand curve slopes upward. CAPITOLO 8: Understanding production: The neoclassical firm and its pitfalls Production and the firm: ➔ What is production? The transformation of primary resources into a good or service that may be sold on a market. How does one produce? With human effort - factors of production. Who produces? Multiple actors. Individuals & organizations like: Business firms, of course. But, also, the State; public organizations; not-for-profit enterprises; NGOs... Tacit agreement among economists to focus on business firms: Thus economic theories of production revolve around the structure, behaviour, and interactions of business firms, which produce commodities ➔ What is a business firm? Simple definition: a business firm is a form of organization devoted to the production of goods and services that will be sold on a market for profit or not-for-profit. The firm's multiple identities:. It is an organization. A collective of individuals whose multiple and durable interactions create value thanks to the individual contributions of each.. It is an institution. It has a set of rules organizing the production of goods and services (especially the division of labour). Neoclassical economists conceptualized production within the context of late XIXth and early XXth century capitalism: Production entirely destined to the market and marketization of goods and services that dominates the production process. Key difference with the classics, for whom production prevailed on (market) distribution. -> Twin paradox. A first paradox: The neoclassical firm is conceived within a theoretical framework celebrating the superiority of the market... But firm and market are two alternative systems of coordination! A second paradox: Neoclassical economics fully embraced methodological individualism. However, business firms are collective entities with complex internal dynamics (the firm as organization), with complex systems of management of social and economic conflicts (the firm as an institution). How did early XXth century neoclassical economics overcome this twin paradox? The neoclassical “solution”: ➔ The business firm is conceived as part and parcel of markets (on the supply side) (Aggregation of individual firms constitutes market supply). ➔ The business firm is treated as an individual agent: a rational agent that seeks to maximize her utility (profits) in a context of scarce resources (factors of production). The neoclassical firm: The neoclassical firm is two things: 1) A production function; 2) An optimizing agent. Key questions, for the neoclassical economist, to understand the firm's behaviour: 1. How much should one produce? 2. How should one produce? Answers: 1. a business firm produces the quantity of a good/service that maximizes the firm's utility, i.e. its profits. 2. Technical choice: the most efficient combination of factors of production. Despite its widespread use in economic textbooks, the neoclassical view of the firm is actually rejected by most economic theorists of the firm: Ronald Coase and the “nature of the firm” Coase's starting point: The “economic system” was identified in most of those works as a competitive market economy. This offered a distorted view of economic reality because in business firms, resource allocation is not achieved through the price mechanism. In other words, there is planning- associated with the work of an authority Coase's questions: Why do firms exist when coordination can be efficiently achieved through the market price mechanism? What does determine the size of business firms? Aim of Coase's essay: The firm vs. market alternative is the object of rational choice between: The price mechanism as the main coordinating device; Or the entrepreneur's authority as the main coordinating device. “Why a firm emerges in a specialized exchange economy.” ➔ Why do agents prefer to organize economic activities through the firm, rather than the market? Coase starts by mentioning two hypotheses, which he discards. 1. Intrinsic preference for a coordinating device alternative to price hierarchy. However, most economic agents prefer to be their own master. 2. Certain agents have a preference for control: They would pay to be able to exert power. Tho Empirical evidence shows the opposite: those who exert control are paid for doing so Coase's hypothesis: transaction costs: The price mecanism is costly. Why? Transactions are costly. 3 types of transaction costs: i. Costs of price discovery; Discovering the “right” price of a commodity can be costly. The presence of experts may reduce but not eliminate that cost. ii. Negotiation costs; Negotiating a transaction (a price) may take time and resources. iii. Contracting costs; Contracting is also costly (monitoring costs) Why the firm? A business firm is alternative to the market. It eliminates the transaction costs associated with market transactions. Transactions and firm size: Coase's main unit of analysis: transactions. Firm size is not defined by quantity of output. why isn't there just one large firm? what does determine vertical integration? Coase's marginalist solution: A firm will (vertically) expand until the cost of organizing one additional transaction within the firm will be equal to (and before it becomes higher than) the cost of organizing that transaction on the market: MC(firm) = MC(market) Merits of Coase's approach: Focus on firms as institutions. Realism. Marginal analysis but applied to transactions, not quantity of output. Shortcomings: Is the problem (of explaining firms) a problem of individual choice? Or are business firms the efficient response to increasingly complex production processes?; Why explain the emergence of firms, and not the emergence of markets?; Coase's persisting adherence to neoclassical tenets like: Methodological individualism, rationality/optimizing assumption, economics as a science of choice. Ignores a whole range of issues, such as the question of ownership and control. CAPITOLO 9: Inputs and costs in the neoclassical production function (part 1) The firm's choices: Neoclassical economics conceptualizes production as the outcome of a series of choices. It is assumed that those choices are made by “the firm”, These choices concern two issues: ➔ The “right” technology of production ➔ The “right” amount to be produced In making these choices, the neoclassical firm incorporate three series of information (data): Data/information about technologies of production Data/information about costs Data/information about prices In taking these decisions “the firm” behaves as an optimizing, rational individual. 2 guidelines: ▪ The firm seeks the most efficient technology of production ▪ The firm seeks to maximize its profits Important assumption: the firm operates in competitive market Production and the production function: Production is the process of turning inputs into outputs. [Inputs = factors of production (Mostly capital (K) and labor (L))] Two key properties: ➔ Inputs are available in finite quantities (scarce resources paradigm) ➔ Inputs are costly The production function is the relationship between the combined quantities of inputs used by a firm and the quantity of output produced by that firm: q = f(K,L) The relationship between inputs and output largely depends on the availability of inputs and such availability varies in time: Economists distinguish between the short run and the long run: ➔ In the short run, some inputs are available only in fixed quantities: We speak of fixed inputs vs. variable inputs (Both factors of production (L and K) can be fixed or variable) ➔ In the long run, all inputs are available in variable quantities In the short run, only one factor is variable, the other is fixed: What is the relationship between inputs and output? The total product curve shows how the quantity of output depends on the quantity of the variable input for a given quantity of the fixed input. If the curve is positively sloped: the relationship is positive Average product: The average quantity of output produced per unit of input Average product of labor: Change in total product is determined by marginal product. Marginal product is the change in output resulting from a one-unit increase in the amount of the variable input. Marginal product initially rises as more additional units of the variable input are added to the production process; then it declines. total production curve and marginal product There are diminishing returns to an input when an increase in the quantity of that input, holding the levels of all other inputs fixed, leads to a decline in the marginal product of that input. With more land (fixed input) each worker can produce more. This shifts the total product curve up. So the MPL of each worker is higher when the farm is larger; the MPL curve shifts up, too. In the long run, the quantity of all inputs can be changed. There is a new relationship between inputs and output: The neoclassical firm can choose its optimal production technology = The optimal combination of inputs. This implies an understanding of the long-run production function with Isoquants. An isoquant is a line that connects all the possible combinations of inputs that enable the production of the same quantity of output: Along the isoquant, the output is constant; only the inputs vary Given the firm's desired output, any change in the combination of inputs involves a trade-off (given the firm's desired output, the firm can increase the quantity used of a factor of production if it decreases the quantity used of the other factor of production) What does determine the rate at which one factor may be substituted with another, along the same isoquant? The technical marginal substitution rate, which corresponds to the slope coefficient of an isoquant: Properties of the MRTS: ➔ It is negative: explains the downward slope of isoquants ➔ It is variable - it decreases along the isoquant: explains the shape of isoquants (convex to the origin) In the long run, the scale of production can change: A firm increases its scale of production when it increases the quantities used of its inputs in the same proportion. The variation of output caused by this is called returns to scale, there are: ➔ Increasing returns to scale if the change in output is higher than the change in inputs ➔ Decreasing returns to scale if the change in output is proportionately lower than the change in inputs ➔ Constant returns to scale if the change in output is proportionately equal to the change in inputs The existence of increasing, decreasing or constant returns to scale depends on the production function. Examples. CAPITOLO 10: Inputs and costs in the neoclassical production function (part 2) Production can be conceptualized as a transformation process: Turning inputs into outputs. Technology captures the physical, material and intellectual aspects of that process. What about the economic aspects? We need to talk about production costs. Production is costly because it requires inputs that are not free. Production costs = costs of acquir- ing/using inputs. With 2 inputs, capital (K) and labor (L), the total production costs are the sum of the cost of capital and the cost of labor: The cost of an input is the product of that input's unit cost and the quantity of that input used in the production process. ➔ For labor, unit costs correspond to wages paid to workers, w. ➔ For capital, unit costs correspond to rents paid to capital owners, r. ➔ Thus total costs amount to: Measuring costs: To measure production costs one should remember the distinction between ac- counting and economic costs: ▪ Accounting cost: Effective spending + amortization (for capital inputs) ▪ Economic cost: Cost derived from the use of resources, including accounting cost AND op- portunity cost ▪ Opportunity cost: Cost derived from the foregone benefits associated with the alternative use of a resource Short-run and long-run costs: In the long run, as we've seen, all inputs are available in variable quanti- ties. In the short run, by contrast, some inputs are available in fixed quantities. -> This distinction translates into a distinction between fixed and variable costs. A fixed cost is a cost that does not depend on the quantity of output produced. It is the cost of the fixed input. A variable cost is a cost that depends on the quantity of output produced. It is the cost of the variable input. In the short run, the total cost of producing a given quantity of output is the sum of the fixed cost and the variable cost of producing that quantity of output. ➔ total cost function: Graphically, this function translates into a curve, the total cost curve, it expresses the rela- tionship between the firm's output and its total costs. The total cost curve becomes steeper as more output is produced, a result of diminishing re- turns. The short-run total curve has two characteristics: ➔ it is positively sloped, indicating a positive relationship between output and total costs; ➔ it has a variable slope, becoming steeper as output increases. Why the latter? Because of increasing marginal costs - or diminishing marginal returns. Marginal cost: Where Δ = change, TC = total cost and Q = quantity of output Why is the marginal cost curve upward sloped? Because there are diminishing returns to inputs in this example. As output increases, the marginal product of the variable input declines. This implies that more and more of the variable input must be used to produce each additional unit of output as the amount of output already produced rises. And since each unit of the variable input must be paid for, the cost per additional unit of output also rises. Average cost: Average total cost (often referred to simply as average cost) = total cost per unit of output produced Average fixed cost = fixed cost per unit of output produced Average variable cost = variable cost per unit of output produced In the short run, as output increases, total cost varies and so does average cost. But how? Increasing output has two opposing effects on average total cost: ➔ The spreading effect: The larger the output, the more output over which fixed cost is spread, leading to lower average fixed cost. ➔ The diminishing returns effect: The larger the output, the more variable input required to pro- duce additional units, which leads to higher average variable cost. Putting the four curves together: Note that:. Marginal cost is upward-sloping because of diminishing returns.. Average variable cost also is upward-sloping but is flatter than the marginal cost curve.. Average fixed cost is downward-sloping because of the spreading effect.. The marginal cost curve intersects the average total cost curve from below, crossing it at its lowest point. The minimum-cost output is the quantity of out- put at which average total cost is lowest. Three general principles that are always true about a firm’s marginal cost and average total cost curves: I. At the minimum-cost output, average total cost is equal to marginal cost. II. At output less than the minimum-cost output, marginal cost is less than average total cost and average total cost is falling. III. At output greater than the minimum-cost output, marginal cost is greater than average total cost and average total cost is rising. the relationship between marginal and average total cost is symmetrical to the relationship be- tween marginal and average product. Short-run versus long-run costs: All inputs are variable in the long run - fixed cost (like factory size) may also vary. The firm will choose its fixed cost in the long run based on the level of output it expects to produce. The long-run average total cost curve: The long-run average total cost curve shows the relationship between output and average total cost when fixed cost has been chosen to minimize average total cost for each level of output. The relationship between short-run and long run average total costs: In the long run, a firm can change its fixed cost by changing its fixed input, together with changes in the variable input: a firm can change the scale of its production. A shift from one short-run average total cost curve to the other indicates returns to scale... Which translate, once costs are taken into consideration, into economies of scale: ➔ There are increasing returns to scale or economies of scale when long run average total cost declines as output increases. ➔ There are decreasing returns to scale or diseconomies of scale when long-run average total cost increases as output increases. ➔ There are constant returns to scale when long-run average total cost is constant as output increases Another way of analyzing long-run cost dynamics: isocosts: An isocost is a curve that graphically rep- resents all the bundles of inputs (all the technologies) that bear the same total cost. Each isocost cor- responds to a particular total cost. Constructing an isocost: Along the isocost, total costs are constant. Thus we have: TC = rK + wL We can transform this equation into a curve equation measuring K as a function of L: An isocost is negatively sloped. The isocost's slope coefficient equals the relative unit price of the two inputs: -w/r; and it has 2 properties: i. It is negative (downward slope) ii. it is constant along the isocost, because the two unit prices are constant (they do not depend on the quantity of inputs or output) The slope of the isocost indicates the quantity of an input that must be foregone so as to increase the quantity used of the other input, maintaining total costs unaltered. CAPITOLO 11: Prices, profits and costs in the neoclassical production function The neoclassical firm faces two crucial economic decisions: 1. A decision concerning the “right” technology: What is the best technology the firm should use, given the desired output? 2. A decision concerning the “right” output: How much output to produce, given the price? The neoclassical model identifies 2 guiding rules of action that helps the firm answer these questions. The choice of the optimal technology: This choice concerns the firm's long run options, when all inputs are available. What technology should the firm choose? Given the desired output, the firm should choose the tech- nology with the lowest cost. -> COST MINIMIZING RULE Given a desired level of output the firm will choose that technology that enables it to produce the de- sired output at a lower cost than all available technologies. Given the isoquant, the firm will choose the point on the isoquant located on the lowest isocost: The optimal technological choice corresponds to the tangency point between isocost and isoquant. Where the two slope coefficients are equal. When the scale of production changes, output changes. When output changes (increases/de- creases), the firm expands/shrinks its production and needs to choose the adequate technology, new isocosts and isoquants will be created. These various tangency points compose the firm's expansion path. Once the various optimal technologies have been identified in correspondence with various output levels, the firm must decide how much output to produce. This choice depends on the relation- ship between output, cost and revenues. The neoclassical model relies on 2 strong assumptions. 1. 1st assumption: profit maximization: The first assumption derives from the view of the firm as an optimizing agent. (The firm is a unitary decision-maker, which behaves like an individ- ual. The firm is rational, seeking to optimize its resources) The firm's utility is its profits. Hence the assumption: the goal of the firm is to maximize its profits. 2. 2d assumption: the firm operates in perfectly competitive markets: The market environ- ment where the firm operates is another crucial assumption underlying the neoclassical model. Why is that important? Because firms, on competitive markets, are price-takers, their production decisions do not influence prices. Markets are perfectly competitive when the following conditions are met: 1. High number of market operators; 2. The good/service exchanged on the market is homogenous; 3. There are no barriers to entry or exit; 4. All market participants have access to the same information. a) High number of market operators: There are many buyers and sellers, each with a small mar- ket share. Market share: the fraction of the total industry output accounted for by that producer’s out- put. b) Product homogeneity: The product is standardized across sellers. Standardized product (aka commodity): consumers regard different sellers’ products as equivalent. c) Absence of barriers at entry and exit: New producers can easily enter into an industry and ex- isting producers can easily leave that industry. d) Information symmetry: All market participants have access to the same information. Revenues, costs and profits: Since each firm is a price-taker, each firm’s total revenue will be equal to price × quantity sold, or TR = P × Q Total revenue thus increases with output. And profit = total revenue − total cost, or Profit = TR – TC How do we know the level of output that enables the firm to maximize its profits? By tracking changes in the profit margin as output, total cost and total revenue change. We know that as output increases, total revenues increase and total costs increase, but not in the same way. Another way of identifying the level of output that maximizes the firm's total profits is by relying on marginal analysis: Analysis of marginal revenues and marginal costs. ➔ Marginal revenue: change in total revenue generated by an additional unit of output: For price-taking firms, MR is simply the good’s market price. ➔ While marginal cost increases as output increases. Optimal output rule: profit is maximized by producing the quantity of output at which the marginal revenue of the last unit produced is equal to its marginal cost (MR = MC). WHY? Each time the firm produces another unit, there are extra costs and extra revenues. If producing an- other unit adds more to revenue than cost, profit will increase. Because if MR > MC, producing more will add to profit. And if MR < MC, producing less will add to profit. Since MR = P for competitive firms, the profit-maximizing rule is: Choose the quantity of output where P = MC. When is production profitable? If TR > TC, the firm is profitable. If TR = TC, the firm breaks even. If TR < TC, the firm incurs a loss. Average total cost and average total revenue: Average total cost is: ATC = TC/Q Average total revenue is: ATR = TR/Q Also: total profits equal total revenues minus total costs: TP = TR – TC Then average total profits equal average total revenues minus average total costs: Average and marginal revenues in competitive firms: For all firms, marginal revenue equals price: MR = P Since, for competitive firms, average revenue also equals price: ATR = P Then: MR = P = ATR Average revenues and costs and profitability: ▪ If ATR > ATC, the firm is profitable. ▪ If ATR = ATC, the firm breaks even. ▪ If ATR < ATC, the firm incurs a loss Profit = TR − TC = (TR/Q − TC/Q) × Q, or Profit = (P − ATC) × Q The break-even price of a price-taking firm is the market price at which it earns zero profit. Decision to stay or leave the market: When the market price falls below the firm's minimum average total cost, this does not imply that the firm should leave the market. In other words, losses don’t mean immediate shutdown. Firms will choose to produce (even at a loss) if they can cover their variable AND SOME of their fixed costs. There is a Shut-down price: minimum average variable cost. A firm will produce at every price above minimum ATC where price intersects the MC curve… …but will stop producing in the short run if the market price falls below the shut-down price... …so the MC curve (above shut-down price) is the firm’s supply curve. If P > break-even (min ATC), firms are profitable. –This profit attracts new entrants. The industry supply curve shows the relationship between the price of a good and the total output of the industry as a whole. The short-run industry supply curve shows how the quantity supplied by an industry depends on the market price given a fixed number of producers. There is a short-run market equilibrium when the quantity supplied equals the quantity demanded, taking the number of producers as given. (The short-run industry supply curve intercepts the demand line at the market price point). New firms enter as long as there is economic profit (P > min ATC). A market is in long-run equilibrium when the quantity supplied equals the quantity demanded, given that sufficient time has elapsed for entry into and exit from the industry to occur. Comparing the short-run and long-run curves: ➔ A higher price attracts new entrants in the long run, raising industry output and lowering price. ➔ A fall in price induces existing producers to exit in the long run, reducing industry output and raising price. The paradox of long-run zero profits: In the long run, on a competitive market, the firms' profits should tend to zero. Why? Because in presence of positive profits - i.e with a market price higher than the break-even price - new firms would be encouraged to enter the market... Until they shift the market supply curve such that the new market price is equal to the break-even price. CAPITOLO 12: Imperfect competition: Monopoly and price discrimination Types of market structure: In order to develop models and make predictions about how producers will behave, we can distinguish four principal models of market structure: 1) Perfect competition; 2) Monopoly; 3) Oligopoly; 4) Monopolistic competition. Differentiating market structures: Market structures can be differentiated among the following four characteristics: i. Number of market participants (producers); ii. Product homogeneity; iii. Barriers at entry/exit; iv. Access to information. Along the first two characteristics Monopolist: a firm that is the only producer of a good with no close substitutes. [A monopolist re- duces the quantity supplied and moves up the demand curve raising the price] Why do monopolies exist? How do they get away with this and protect their profit from new firms? Profits will not persist in the long run unless there is a barrier to entry. Such barriers are not simply “ar- tificial” restrictions to market participation. There are legal monopolies, but also natural monopo- lies. (An industry controlled by a monopolist is known as a monopoly). Market power: the ability of a firm to raise / manipulate prices. Barriers to entry are essential for monopolies. They generate profit for the monopolist in the short run and long run. They can take the form of: a) Control of natural resources or inputs; b) Increasing returns to scale; (A natural monopoly exists when increasing returns to scale (economies of scale) provide a large cost advantage to a single firm. This implies that in some cases, monopolies are actually more efficient than perfect competition. Especially in network industries and in infrastructures. A given quantity of output is produced more cheaply by one large firm than by (the sum of) two or more smaller firms) c) Technological superiority; (A firm that maintains a consistent technological advantage over potential competitors can establish itself as a monopolist) d) Government-made barriers, including patents and copyrights. (Apatent gives an inventor a temporary monopoly in the use or sale of an invention. A copyright gives the creator of a liter- ary or artistic work sole rights to profit from that work. Governments can impose a monopoly by law) How a monopolist maximizes profit: Like competitive firms, in the neoclassical view monopolists aim to maximize profit. But there is a major difference in the paths to profit maximization for competitive firms and monopolists: Competitive firms cannot choose price. They are price-takers. Monopolists can. They are price-makers. Remember that, for competitive firms, P = AR = MR. Instead, for monopolists, P = AR ≠ MR, since mo- nopolistic firms represent total market supply, the demand they face is the entire market demand. Also price and market demand are negatively correlated. (As the price declines, market demand in- creases and viceversa), thus, as the quantity of a commodity supplied by the monopolist increases, the monopolist’s average revenue decreases. If AR declines as Q increases, then MR declines even more, Thus an increase in production by a mo- nopolist has two opposing effects on revenue: ▪ A quantity effect: one more unit is sold, increasing total revenue by the price at which the unit is sold; ▪ A price effect: to sell the last unit, the monopolist must cut the market price on all units sold; this decreases total revenue. So the monopolist’s profit maximization consists of two steps: I. Choosing a quantity; Rule: Choose Q where MR = MC II. Choosing a price. The monopolist chooses the highest price it can get away with, which is the highest price consumers will pay for that quantity. Rule: Once chosen Q, the monopolist will follow the graph to the demand curve, which shows how much consumers will pay. Monopolists don’t have supply curves—since they control prices there is no set relationship be- tween price and quantity supplied. Monopoly profit comes at consumers’ expense: When a monopoly raises prices and lowers Q, con- sumer surplus falls and deadweight loss is created. To avoid this, government policy attempts to prevent monopoly behaviour with antitrust policies. Dealing with a natural monopoly: They bring lower costs, but there’s no guarantee the firm will volun- tarily pass along its cost savings to consumers. What can public policy do about this? Two common answers: Public (government) ownership. A solution not loved by mainstream economists. Price regulation: a price ceiling imposed on a monopolist does not create shortages if it is not set too low. Monopoly and monopsony: A monopsony exists when there is only one buyer of a good or service. Price discrimination: So far we’ve been assuming our firm is a single-price monopolist: it offers its product to all consum- ers at the same price. Some firms practice price discrimination: they charge different prices to different consumers for the same good. When perfect price discrimination can be employed, a firm will charge each customer a different price, the maximum price each is willing to pay. Under perfect price discrimination, the firm captures all consumer surplus as profit. (It’s like haggling at the flea market) There is no deadweight loss because all mutually beneficial transactions are exploited. There is zero consumer surplus because the entire surplus is captured by the monopolist in the form of profit. Common techniques for price discrimination: Advance purchase restrictions. Prices are lower for those who purchase well in advance. Volume discounts. The price is lower if you buy a large quantity. Two-part tariffs. A customer pays a flat fee upfront and then a per unit fee on each item pur- chased. CAPITOLO 13: Oligopoly An oligopoly is a market that is dominated by a small number of firms. The product exchanged on the market is generally homogenous and there are barriers at entry. In consequence, oligopolistic firms have market power: They can influence the market price by output decisions. Studying olipolistic behavior is complicated because it’s not a single firm considering its costs and pricing in a vacuum (like perfectly competitive firms and monopolies): The profits of a large firm de- pend heavily on the actions taken by other large firms. Measuring oligopoly: To get a better picture of market structure, economists often use the Her- findahl–Hirschman Index, or HHI. The HHI for an industry is the sum of the squares of each firm’s share of market sales. example, if there are three firms with 60%, 25%, and 15% market share each: HHI = 60^2 + 25^2 + 15^2 = 4,450 HHI in regulatory practice: o HHI of less than 1,000 indicates a strongly competitive market. o HHI of 1,000 to 1,800 indicates a somewhat competitive market. o HHI above 1,800 indicates an oligopoly. (If HHI is above 1,000, a merger that results in a significant increase in the HHI will receive spe- cial scrutiny and is likely to be disallowed by antitrust authorities). Duopoly: Some of the key issues can be understood by looking at the simplest case: duopoly. Duopoly: an oligopoly consisting of only two firms. With only two firms in the industry, each realizes that profits would be higher if it limited its production (and kept prices higher). Duopolists may thus consider cooperating. Cooperation between firms may be profitable, but it is unstable—and illegal in some cases. Collusion: firms cooperating to raise each others’ profits. (illegal) The strongest form of collusion is a cartel, an agreement by several producers to restrict output in or- der to increase their joint profits. Non-cooperation: Non-cooperative behavior: firms ignoring the effects of their actions on each oth- ers’ profits. ➔ To maximize profit, how will firms behave? Will each firm act in its own self-interest, even though this drives down everyone’s profits (non- cooperative)? or Will they engage in collusion, reaching and holding to an agreement that max- imizes their combined profits? It depends. Oligopolistic firms typically find themselves in strategic situations that can be modelled using game theory. Remember: game theory is the study of behavior in situations of interdependence. A duopoly can be typically described as a prisoner’s dilemma, where: Each player has an incentive to choose an action that benefits itself at the other player’s expense. When both players act in this way, both are worse off than if they had acted cooperatively. Cournot model: A model of the behaviour of duopolistic firms, focuses on each firm's reaction to the other firm's production decisions. Each firm makes decisions on the output level, each firm seeks to maximize its profit following the neoclassical guiding rules of action (Marginal revenue must equal marginal cost). In the Cournot model, the two firms can reach an equilibrium: Each correctly anticipates the output decisions of the other firm. Overcoming the prisoners' dilemma: if a game is played repeatedly, players may engage in strategic behavior, sacrificing short-run profit to influence future behavior. -> Tit for tat: a strategy of playing cooperatively at first, then doing whatever the other player did in the previous period. Oligopoly in practice: Antitrust legislation: Oligopolies operate under legal restrictions in the form of antitrust policy. Antitrust policies: efforts undertaken by the government to prevent oligopolistic industries from becoming or behaving like monopolies. Tacit collusion: Many do succeed in achieving tacit collusion (unspoken agreements). However, tacit collusion is limited by a number of factors, including: less concentration. complex products and pric- ing scheme, differences in interests, bargaining power of buyers. Product differentiation and price leadership: When collusion breaks down and prices collapse, there is a price war. To limit competition, oligopolists often engage in product differentiation, an attempt by a firm to convince buyers that its product is different from the products of other firms in the indus- try. Oligopolists often avoid competing directly on price, engaging in nonprice competition through advertising and other means instead. In price leadership one firm sets its price first, and other firms follow. CAPITOLO 14: Monopolistic competition Monopolistic competition is a market structure that’s a little like monopoly and a little like perfect competition. Specifically, monopolistic competition has the following characteristics: ▪ Many market participants. ▪ Products similar but not identical. ▪ Free entry into and exit from the industry in the long run. example: restaurants are monopolistic competitors. Product differentiation: There are three important forms of product differentiation among firms: ) Differentiation by style or type; Small cars versus SUVs. ) Differentiation by location; Dry cleaner near home versus cheaper dry cleaner far away. ) Differentiation by quality Ordinary chocolate versus gourmet chocolate. Industry features: There are two important features of industries with differentiated products: ) Competition among sellers: entry by more producers reduces the quantity each existing pro- ducer sells; ) Value in diversity: consumers gain from the increased diversity of products Short-run profit maximization: Same profit maximizing rule as previously used: Produce the Q at which MR = MC; and like monopoly firms, set price according to demand. Adjustment to long-run equilibrium: effects of entry: New entrants mean fewer customers for the original firms: Demand and MR shift left. (Economic) profits fall to zero: Firms break even and new entry stops effects of exit: New exits mean more customers for the remaining firms: Demand and MR shift right. (Economic) profits fall to zero: firms break even and exits stop. Is monopolistic competition efficient? Society's perspective: Firms in a monopolistically competitive industry have excess capacity: They produce less than the output at which average total cost is minimized.

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